Market liquidity
In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the price at which an asset can be sold, and how quickly it can be sold. In a liquid market, the trade-off is mild: one can sell quickly without having to accept a significantly lower price. In a relatively illiquid market, an asset must be discounted in order to sell quickly.[1][2] Money, or cash, is the most liquid asset because it can be exchanged for goods and services instantly at face value.[1]
Overview
A liquid asset has some or all of the following features: It can be sold rapidly, with minimal loss of value, anytime within market hours. The essential characteristic of a liquid market is that there are always ready and willing buyers and sellers. It is similar to, but distinct from, market depth, which relates to the trade-off between quantity being sold and the price it can be sold for, rather than the liquidity trade-off between speed of sale and the price it can be sold for. A market may be considered both deep and liquid if there are ready and willing buyers and sellers in large quantities.
An illiquid asset is an asset which is not readily salable (without a drastic price reduction, and sometimes not at any price) due to uncertainty about its value or the lack of a market in which it is regularly traded.[3] The mortgage-related assets which resulted in the subprime mortgage crisis are examples of illiquid assets, as their value was not readily determinable despite being secured by real property. Before the crisis, they had moderate liquidity because it was believed that their value was generally known.[4]
Speculators and market makers are key contributors to the liquidity of a market or asset. Speculators are individuals or institutions that seek to profit from anticipated increases or decreases in a particular market price. Market makers seek to profit by charging for the immediacy of execution: either implicitly by earning a bid/ask spread or explicitly by charging execution commissions. By doing this, they provide the capital needed to facilitate the liquidity. The risk of illiquidity does not apply only to individual investments: whole portfolios are subject to market risk. Financial institutions and asset managers that oversee portfolios are subject to what is called "structural" and "contingent" liquidity risk. Structural liquidity risk, sometimes called funding liquidity risk, is the risk associated with funding asset portfolios in the normal course of business. Contingent liquidity risk is the risk associated with finding additional funds or replacing maturing liabilities under potential, future-stressed market conditions. When a central bank tries to influence the liquidity (supply) of money, this process is known as open market operations.
Effect on asset values
The market liquidity of assets affects their prices and expected returns. Theory and empirical evidence suggest that investors require higher return on assets with lower market liquidity to compensate them for the higher cost of trading these assets.[5] That is, for an asset with given cash flow, the higher its market liquidity, the higher its price and the lower is its expected return. In addition, risk-averse investors require higher expected return if the asset's market-liquidity risk is greater.[6] This risk involves the exposure of the asset return to shocks in overall market liquidity, the exposure of the asset's own liquidity to shocks in market liquidity and the effect of market return on the asset's own liquidity. Here too, the higher the liquidity risk, the higher the expected return on the asset or the lower is its price.[7]
One example of this is a comparison of assets with and without a liquid secondary market. The liquidity discount is the reduced promised yield or expected return for such assets, like the difference between newly issued U.S. Treasury bonds compared to
Futures
In the
There is also dark liquidity, referring to transactions that occur off-exchange and are therefore not visible to investors until after the transaction is complete. It does not contribute to public price discovery.[9]
Banking
In banking, liquidity is the ability to meet obligations when they come due without incurring unacceptable losses. Managing liquidity is a daily process requiring
Banks can generally maintain as much liquidity as desired because bank deposits are insured by governments in most developed countries. A lack of liquidity can be remedied by raising deposit rates and effectively marketing deposit products. However, an important measure of a bank's value and success is the cost of liquidity. A bank can attract significant liquid funds. Lower costs generate stronger profits, more stability, and more confidence among depositors, investors, and regulators.
Stock market
The market liquidity of
See also
References
- ^ a b Mike Moffatt. "Liquidity - Dictionary Definition of Liquidity". About.com Education. Archived from the original on 17 April 2015. Retrieved 27 May 2015.
- ^ Keynes, John Maynard. A Treatise on Money. Vol. 2. p. 67.
- ^ "TradeLive". TradeLive.in. Archived from the original on 26 December 2017. Retrieved 27 May 2015.
- S2CID 153899413.
- ^ Yakov Amihud and Haim Mendelson, "Asset Pricing and the Bid-Ask Spread." Journal of Financial Economics 17, 1986.
- ^ Viral Acharya and Lasse Heje Pedersen, "Asset pricing with liquidity risk." Journal of Financial Economics 77, 2005.
- ^ See a review in Amihud, Mendelson, and Pedersen, Market Liquidity, Cambridge University Press, 2013. http://www.cambridge.org/bus/catalogue/catalogue.asp?isbn=9780521139656[page needed]
- doi:10.1086/386528. Retrieved 26 September 2022.
- ^ "Mifid ushers in a new era of trading". Financial Times. Archived from the original on 10 December 2022. Retrieved 27 May 2015.
- ^ Mueller, Jim. "Understanding Financial Liquidity". Investopedia.com. Investopedia US. Archived from the original on 3 May 2018. Retrieved 11 August 2014.
Sources
- "Liquidity: Finance in motion or evaporation", lecture by Michael Mainelli at Gresham College, 5 September 2007 (available for download as an audio or video file, as well as a text file)
- The role of time-critical liquidity in financial markets by David Marshall and Robert Steigerwald (Federal Reserve Bank of Chicago)
- Financial market utilities and the challenge of just-in-time liquidity by Richard Heckinger, David Marshall, and Robert Steigerwald (Federal Reserve Bank of Chicago)
Further reading
- Christoph G. Rösch: Market Liquidity: An empirical analysis of the impact of the financial crisis, ownership structures and insider trading. 1. Auflage. Shaker, ISBN 978-3844-01237-8.
- Abudy, Menachem Meni; Raviv, Alon (2016). "How much can illiquidity affect corporate debt yield spread?". Journal of Financial Stability. 25: 58–69. .