In this paper we (a) quantify equity liquidity using a measure of price impact, the change in a firm's stock price associated with its observed net trading volume; (b) relate the measured price impact to a set of predetermined firm characteristics that serve as proxies for the severity of adverse selection in the equity market, the non-information based costs of making a market in the stock, and the extent of shareholder heterogeneity; and (c) compare, out-of-sample, our characteristic-based estimates of price impact to actual price impacts. Increasing the magnitude of net turnover during a 5-minute interval by 0.1% of the shares outstanding produces an average incremental price effect of 2.65% for NYSE and AMEX listed firms and 1.85% for NASDAQ firms. These averages, however, mask considerable cross-sectional variation. We present evidence that liquidity varies cross-sectionally as a function of predetermined firm characteristics as predicted by theories based on adverse selection, market making costs, and shareholder heterogeneity. We also find intra-day patterns, with the price impact being higher at the beginning and end of the trading day relative to the middle of the day. For a large set of institutional trades we examine the relation between actual price impact and that predicted out-of-sample using the cross sectional relation between firm characteristics and price impact. We find numerous aspects of trade execution which are significantly related to the price impact forecast error in intuitive ways: for example, the predicted price impact overestimates the actual price impact for very large trades, for trades executed in a more patient manner, and for trades where the institution pays higher commissions.
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