The theory and practice of FX and government securities market liquidity

The subject of our study is market liquidity, which is an important element of the functioning of financial markets.

Adequate liquidity of markets is of great significance from the point of view of both market participants and the central bank. On the one hand, of all market segments an examination was made of the domestic forint-euro spot FX market,

which is of key importance due to the openness of the country’s economy. On the other hand, an analysis was made of the market of forint denominated government bonds, which plays a crucial role in the transmission of the central bank’s interest rate policy.

Several useful lessons can be drawn from looking over the literature dealing with the measurement of market liquidity.

First, liquidity can unambiguously be interpreted only alongside several liquidity dimensions. The so-called tightness dimension of liquidity can be measured by the transaction costs, a typical indicator of which is the bid-ask spread.

Another important dimension is market depth, and market turnover is most often used in literature as its approximation indicator. Accordingly, in the course of empirical examinations, the two main liquidity indicators, i.e. the bid-ask spread

and turnover were examined not only separately, but also in terms of their relationship. Another important conclusion to be drawn is that individual liquidity indicators may often signal changes in different directions of market liquidity, and this is one of the reasons why it is important to look at individual indicators together.

JEL Classification numbers: F31, G14, G15.

Keywords: Market liquidity, financial markets, bid-ask spread, market turnover.