Latent liquidity: A new measure of liquidity, with an application to corporate bonds

Abstract

We present a new measure of liquidity known as ''latent liquidity'' and apply it to a unique corporate bond database. Latent liquidity is defined as the weighted average turnover of investors who hold a bond, in which the weights are the fractional investor holdings. It can be used to measure liquidity in markets with sparse transactions data. For bonds that trade frequently, our measure has predictive power for both transaction costs and the price impact of trading, over and above trading activity and bond-specific characteristics thought to be related to liquidity. Additionally, this measure exhibits relationships with bond characteristics similar to those of other trade-based measures. r

Rollover Risk and Credit Risk

“…The overall effect is unclear and worth exploring in future research. 6 As documented by a series of empirical papers (e.g., Bessembinder, Maxwell, and Venkataraman (2006), Edwards, Harris, and Piwowar (2007), Mahanti et al (2008), and Bao, Pan, and Wang (2011)), the secondary markets for corporate bonds are highly illiquid. The illiquidity is reflected attribute this cost to either the market impact of the trade (e.g., Kyle (1985)), or the bid-ask spreads charged by bond dealers (e.g., Glosten and Milgrom (1985)).…”

Latent Liquidity and Corporate Bond Yield Spreads

“…The concept of latent liquidity that is used in this paper draws from Mahanti et al (2006). That paper introduces the measure and relates it to bond-specific characteristics, such as maturity, age, coupon, rating, the presence or absence of put/call options and other covenants.…”

“…In this paper, we provide a partial answer to this question using a new measure of liquidity, called latent liquidity, proposed by Mahanti et al (2006), which is based on the pattern of holdings of bonds by investors, and thus does not require a large number of observed trades. This measure weights the turnover of the funds that own the bond by their fractional holdings; thus, it is a measure of the accessibility of a bond to market participants.…”

“…Our approach, using this metric of liquidity, has several unique advantages, as argued by Mahanti et al (2006). First, it allows us to access information across a large number of dealers.…”

“…Section 3 describes our data sources. Section 4 discusses the latent liquidity measure proposed by Mahanti et al (2006) and the manner in which we measure the non-default component of corporate bond spreads. Section 5 discusses the results of our study.…”