When Market Illiquidity Generates Volume

In this paper, we develop an extended framework of the daily return-volume relationship which incorporates information and liquidity shocks. First, we distinguish between two trading strategies, information-based and liquidity-based trading and suggest that their respective impacts on returns and volume should be modeled differently. Second, we extend the microstructure setting of Grossman and Miller (1988) at the daily frequency in order to model the impact of liquidity frictions on daily trading characteristics. In particular, the model explains how the liquidity frictions can increase the daily traded volume, in the presence of liquidity arbitragers. Finally, based on this structural framework, we extend the econometric model of Tauchen and Pitts (1983) and derive a modified mixture of distribution hypothesis (MDH) model with two latent factors related to information and liquidity. This model allows us to infer the presence of liquidity frictions from daily data. We thus propose a stock-specific liquidity measure using daily return and volume observations of FTSE100 stocks.