How is the Amihud illiquidity ratio calculated and used?

Question

AcadiFi · Accepted Answer

The Amihud illiquidity ratio (2002) measures the average daily absolute return per dollar of trading volume: ILLIQ_i = (1/D) * sum_{d=1}^D |r_{i,d}| / V_{i,d}, where |r| is absolute daily return and V is daily dollar volume. Higher ILLIQ = more illiquid (bigger price moves per dollar traded).

Example: Arrowhead Beverages over 20 trading days has average |return| = 1.4% = 0.014, average dollar volume $2.8M. ILLIQ = 0.014 / 2,800,000 = 5.0e-9. Compared to Cornerstone Financial with |return| = 0.9% and volume $42M, ILLIQ = 2.14e-10 — much more liquid.

Advantages: requires only daily data (price and volume), easy to compute across any asset with such data, well-correlated with microstructure-based measures like Kyle's lambda but cheaper. Used widely in academic asset pricing (liquidity premium) and practical risk management (liquidity screens, position sizing).

```mermaid
flowchart LR
  A[Daily |return|] --> C[ILLIQ = avg|r|/$vol]
  B[Daily $ volume] --> C
  C --> D[Higher = less liquid]
```

Risk applications: rank portfolio by ILLIQ to identify liquidity-vulnerable positions. Stress test: simulate volume declining (e.g., 50%) and recompute ILLIQ to estimate crisis liquidation costs. Portfolio-weighted ILLIQ is a single-number liquidity exposure metric for reporting. Downsides: noisy at daily horizon, biased by microstructure effects like stale prices, and doesn't distinguish temporary vs permanent impact.

How is the Amihud illiquidity ratio calculated and used?

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