Market Liquidity and Price Discovery in the Pakistan Stock Exchange: The Role of Trading Volume and Investor Participation

Abstract

This paper looks at the dynamic interplay between market liquidity, trading volume, investor participation, and price discovery on the Pakistan Stock Exchange (PSX). Based on daily records for the KSE-100 Index alongside actively traded equities from 2018–2026, we gauged liquidity via the Amihud illiquidity ratio, the Corwin–Schultz high–low spread estimator, and turnover, tracking trading activity and investor participation through trading volume and trade counts. Following basic descriptive checks and unit-root tests, we set up a Vector Autoregression (VAR) system and ran Granger causality tests alongside impulse-response functions and forecast error variance decompositions. Returns were significantly Granger-caused by trading volume, and both transactions and illiquidity added significant predictive power for upcoming returns as well. A reverse channel was clearly present: past returns significantly predicted subsequent trading volume, transaction counts, and illiquidity, pointing to a two-way relationship between price adjustments and trading activity. Impulse responses showed that shocks to trading activity pushed returns up briefly, whereas illiquidity shocks triggered negative return movements that took longer to fade. As the forecast horizon stretched out, liquidity and trading activity accounted for a progressively larger share of return variance. These patterns held up across a battery of sensitivity checks that swapped in alternate liquidity metrics, weekly data, sub-periods, and individual firm-level series. Taken together, the evidence underlines just how much liquidity and market participation matter for price formation and short-term price discovery on the PSX.