Run lengths and liquidity

We develop a market-wide illiquidity risk factor based on run lengths and find that it is priced using standard asset-pricing specifications. Our theoretical framework of equity returns derives the result that average run lengths are related to common measures of liquidity such as trading volume and trade price-impact. This relationship holds irrespective of the observation frequency in the computation of run lengths. Thus, liquidity can be detected by examining a stock’s run length signature, thereby providing a statistical mechanics link across illiquidity metrics. Tests using daily equity return data for all stocks over the period 1962-2005 find that run lengths are decreasing in turnover, and increasing with bid-ask spreads, and price-impact. We also show that illiquidity is an important risk factor in explaining equity returns.