Liquidity Risk
in Sri Lanka's Equity Market
Behind every trade lies a hidden cost — in Sri Lanka’s equity market, that cost is often liquidity. Unlike developed markets where deep order books absorb trades with little friction, frontier markets like Sri Lanka tell a different story. Here, small volumes can move prices significantly, and the lack of consistent participation leaves the market vulnerable to shocks. In this section, we uncover the silent force of illiquidity: how it evolves, how it differs across industries, and how stress scenarios reveal just how fragile the system can become.
Market Amihud Illiquidity
Amihud illiquidity measures the average price response per unit of trading volume — a proxy for how costly it is to execute trades without impacting the market. In Sri Lanka’s frontier market context, where institutional depth is limited, this metric highlights the price pressure even relatively small trades can exert. The timeline reveals how market-wide liquidity fluctuates in response to investor behavior, risk sentiment, and broader macroeconomic events.
Insights:
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Major liquidity spikes observed between 2018 and 2019 were primarily driven by unusually illiquid behavior in a select few securities. While the broader market appeared stable, extreme illiquidity in individual names pushed up the aggregate Amihud metric significantly — a reminder that in shallow markets, idiosyncratic stock-level events can distort overall liquidity perception.
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Even in more recent years, the persistence of elevated Amihud readings during stress periods, such as the 2022 default, reflects ongoing systemic fragility. These shifts may not be immediately visible from price movements alone, making this metric a valuable lens for uncovering underlying execution risk.
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The lack of a consistent return to “highly liquid” conditions emphasizes that liquidity in Sri Lanka is not cyclical, but structurally constrained — reinforcing the need for patient capital, staggered entries/exits, and liquidity-aware risk budgeting.
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Going forward, integrating this metric into a live dashboard could help investors and fund managers quantify execution risk in real-time, especially during volatile macro periods.
Liquidity Score
PCA-based*
The liquidity score is derived using Principal Component Analysis (PCA) to combine Amihud Illiquidity and turnover into a single standardized measure. This composite reflects the market’s overall liquidity health, capturing both the cost of trading and the depth of participation. When the score rises, liquidity conditions tighten — suggesting increased price impact and reduced volume support — while lower scores indicate more favorable trading environments. PCA is used here to reduce two key liquidity indicators — Amihud Illiquidity and turnover — into a single score that captures the dominant pattern in market liquidity conditions. By standardizing and combining both dimensions, PCA ensures that the resulting score is not biased toward one metric or scale. The first principal component represents the strongest co-movement between price impact and trading volume, making it an effective signal for identifying tightening or easing liquidity in real time.
Insights:
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Sharp upward spikes between late 2020 and early 2022 indicate periods where both price impact and turnover conditions deteriorated simultaneously — reinforcing how liquidity in frontier markets can unwind rapidly when volatility or capital flight occurs.
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The persistence of neutral-to-tight liquidity conditions after 2022 shows that the market has not meaningfully recovered in structural terms, even if volatility appears lower. This underscores a disconnect between surface-level calm and actual tradability.
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Negative liquidity scores prior to 2020 suggest relatively stronger conditions in the pre-crisis era, before global and domestic shocks revealed the market’s limited resilience. This shift may reflect a broader decline in investor participation or institutional support.
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For investors, this score offers a quantitative filter for timing trades or adjusting exposure — particularly useful when combined with macro event monitoring or fund flow data.
Amihud Illiquidity
Across Industries
Every industry tells a different story when it comes to Amihud Illiquidity. While some sectors experience brief surges, others remain persistently dry — revealing the structural gaps in market depth that define Sri Lanka’s fragmented equity landscape.
Click image to enlarge
Insights:
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Commercial & Professional Services and Consumer Services stand out with chronically high illiquidity, hinting at shallow order books and concentrated ownership that can distort trade execution.
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Sectors like Materials, Energy, and Consumer Durables exhibit intermittent but severe spikes, suggesting that even isolated stock-level events can distort liquidity at the industry level.
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Telecommunication Services exhibits consistently low Amihud Illiquidity despite active trading, suggesting strong liquidity conditions where large trades can be executed with minimal price disruption. This distinguishes it from many other sectors in the Sri Lankan market, where even small trades can cause notable price shifts.
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For institutional investors, these patterns highlight the value of liquidity-aware sector rotation — not just based on returns, but on the cost of entering and exiting positions without disrupting price.
Liquidity Under Pressure!
Stress Testing the Market
Stress testing provides a lens into how fragile market liquidity can become when conditions tighten. In this comparison, the blue line reflects the PCA-based liquidity score under normal market conditions, while the red line simulates a stressed environment — constructed by reducing trading volume by 50% and increasing Amihud illiquidity by 1.5×. Both sets of data are processed through the same standardized scaler and PCA model to ensure a fair and consistent comparison. The result reveals just how sensitive the Sri Lankan market is to even modest shocks in participation, uncovering the structural vulnerabilities that lie beneath periods of apparent stability.
Insights:
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The consistently lower (worse) stressed liquidity score across the entire timeline highlights that even during normal market conditions, Sri Lanka’s market has limited liquidity resilience. A modest shock to volume amplifies execution risk meaningfully.
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Spikes during events like COVID-19 (2020), the sovereign default (2022), and post-crisis volatility (2023) show the stressed score diverging sharply from the normal score — quantifying the amplified liquidity strain during crisis periods.
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The fact that the gap between normal and stressed scores remains wide even in “calmer” periods suggests that liquidity conditions are not just situational — they’re structurally vulnerable.
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From a risk management perspective, this chart supports the use of liquidity-adjusted VaR, conservative capital allocation during macro risk periods, and tiered execution strategies that price in potential liquidity slippage.
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Because the same scaler and PCA model are applied to both normal and stressed data, this ensures that the comparison is methodologically consistent, and any gap reflects real sensitivity — not model bias.