The Liquidity of the Market Portfolio

Asset pricing theory suggests that liquidity only affects prices if claims to the market portfolio display time-varying liquidity. Most empirical research on aggre-gate liquidity has had to rely on indirect measures constructed from liquidities of individual stocks. These measures may differ significantly from the liquidity of an claim on the index itself. We directly study the liquidity of the market portfolio via the price impact of order flow in the S&P 500 futures. Using identification through heteroskedasticity to address simultaneity of order flow and returns, we find that flow strongly and permanently affects prices. We construct a directly observable ex-ante, real-time measure of illiquidity via the slope of the limit order book. This measure is a highly significant predictor of subsequent price impact, with a coefficient that is typically close to one. From its dynamics we find that (i) the nonflow component of return volatility decreases liquidity, but the volatility of order flow does not; (ii) trading volume has only a transient effect on liquidity; and (iii) liquidity varies positively with order flow itself. Our results point to lim-ited risk bearing capacity, rather than asymmetric information or temporary price pressure, as a primary determinant of market illiquidity