High-Frequency Arbitrage and Market Illiquidity

During times of market stress, arbitrage capital cannot be timely deployed, and assets trade away from fundamentals. This gives rise to transitory price volatility, a latent factor that signals difficulties in the market-making process. I propose a market-wide illiquidity measure based on SPY's transitory volatility (SPY is an ETF that tracks the S&P500). While related to existing illiquidity proxies, the proposed measure provides additional information. It also captures commonality in stock-level illiquidity, and it is priced in the market. An investment strategy based on it earns, on average, a 8.64% annual return. This premium cannot be explained by classical risk factors, including existing illiquidity measures.