In
business
Business is the practice of making one's living or making money by producing or Trade, buying and selling Product (business), products (such as goods and Service (economics), services). It is also "any activity or enterprise entered into for pr ...
,
economics
Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services.
Economics focuses on the behaviour and intera ...
or
investment
Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort.
In finance, the purpose of investing i ...
, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an
asset
In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value ...
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.
Money, or
cash
In economics, cash is money in the physical form of currency, such as banknotes and coins.
In bookkeeping and financial accounting, cash is current assets comprising currency or currency equivalents that can be accessed immediately or near-imm ...
, is the most liquid asset because it can be exchanged for
goods and services
Goods are items that are usually (but not always) tangible, such as pens, physical books, salt, apples, and hats. Services are activities provided by other people, who include architects, suppliers, contractors, technologists, teachers, doctor ...
instantly at face value.
Overview
![Old church building for sale, Widnes](https://upload.wikimedia.org/wikipedia/commons/5/51/Old_church_building_for_sale%2C_Widnes.JPG)
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
In finance, market depth is a real-time list displaying the quantity to be sold versus unit price. The list is organized by price level and is reflective of real-time market activity. Mathematically, it is the size of an order needed to move th ...
, 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. The mortgage-related assets which resulted in the
subprime mortgage crisis
The United States subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the Financial crisis of 2007–2008, 2007–2008 global financial crisis. It was triggered by a large decline ...
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.
Speculators
In finance, speculation is the purchase of an asset (a commodity, goods, or real estate) with the hope that it will become more valuable shortly. (It can also refer to short sales in which the speculator hopes for a decline in value.)
Many s ...
and
market maker
A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the ''bid–ask spread'', or ''turn.'' The benefit to the firm is that it ...
s 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 maker
A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the ''bid–ask spread'', or ''turn.'' The benefit to the firm is that it ...
s 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
Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.
Types
Market liquidity – An asset cannot be so ...
. 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
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...
tries to influence the liquidity (
supply
Supply may refer to:
*The amount of a resource that is available
**Supply (economics), the amount of a product which is available to customers
**Materiel, the goods and equipment for a military unit to fulfill its mission
*Supply, as in confidenc ...
) 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. 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. 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.
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
off the run
In finance, an on the run security or contract is the most recently issued, and hence most liquid, of a periodically issued security. On the run securities are generally more liquid and trade at a premium to other securities. Other, older issues ar ...
treasuries with the same term to maturity. Initial buyers know that other investors are less willing to buy off-the-run treasuries, so the newly issued bonds have a higher price (and hence lower yield).
Futures
In the
futures markets
A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts defined by the exchange. Futures contracts are derivatives contracts to buy or sell specific quantities of a commodity or ...
, there is no assurance that a liquid market may exist for offsetting a commodity contract at all times. Some future contracts and specific delivery months tend to have increasingly more trading activity and have higher liquidity than others. The most useful indicators of liquidity for these contracts are the trading volume and
open interest Open interest (also known as open contracts or open commitments) refers to the total number of outstanding derivative contracts that have not been settled (offset by delivery).
For each buyer of a futures contract there must be a seller. From the t ...
.
There is also
dark liquidity
In finance, a dark pool (also black pool) is a private forum (alternative trading system or ATS) for trading securities, derivatives, and other financial instruments.[price discovery
In economics and finance, the price discovery process (also called price discovery mechanism) is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers.
Overview
Price discovery is diff ...](_blan ...<br></span></div>, 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 <div class=)
.
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
bankers
A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets.
Because ...
to monitor and project cash flows to ensure adequate liquidity is maintained. Maintaining a balance between short-term assets and short-term liabilities is critical. For an individual bank, clients' deposits are its primary
liabilities (in the sense that the bank is meant to give back all client deposits on demand), whereas reserves and loans are its primary
asset
In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value ...
s (in the sense that these loans are owed to the bank, not by the bank). The investment portfolio represents a smaller portion of assets, and serves as the primary source of liquidity. Investment securities can be liquidated to satisfy deposit withdrawals and increased loan demand. Banks have several additional options for generating liquidity, such as selling loans,
borrowing from other banks, borrowing from a
central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...
, such as the
US Federal Reserve bank, and raising additional capital. In a worst-case scenario, depositors may demand their funds when the bank is unable to generate adequate cash without incurring substantial financial losses. In severe cases, this may result in a
bank run
A bank run or run on the bank occurs when many clients withdraw their money from a bank, because they believe the bank may cease to function in the near future. In other words, it is when, in a fractional-reserve banking system (where banks no ...
. Most banks are subject to legally mandated requirements intended to help avoid a
liquidity crisis In financial economics, a liquidity crisis is an acute shortage of ''liquidity''. Liquidity may refer to market liquidity (the ease with which an asset can be converted into a liquid medium, e.g. cash), funding liquidity (the ease with which borrow ...
.
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
![Board_at_the_Toronto_Stock_Exchange](https://upload.wikimedia.org/wikipedia/commons/4/49/Board_at_the_Toronto_Stock_Exchange.jpg)
The market liquidity of
stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
depends on whether it is
listed
Listed may refer to:
* Listed, Bornholm, a fishing village on the Danish island of Bornholm
* Listed (MMM program), a television show on MuchMoreMusic
* Endangered species in biology
* Listed building, in architecture, designation of a historicall ...
on an
exchange
Exchange may refer to:
Physics
*Gas exchange is the movement of oxygen and carbon dioxide molecules from a region of higher concentration to a region of lower concentration. Places United States
* Exchange, Indiana, an unincorporated community
* ...
and the level of buyer interest. The
bid/ask spread is one indicator of a stock's liquidity. For liquid stocks, such as
Microsoft
Microsoft Corporation is an American multinational technology corporation producing computer software, consumer electronics, personal computers, and related services headquartered at the Microsoft Redmond campus located in Redmond, Washing ...
or
General Electric
General Electric Company (GE) is an American multinational conglomerate founded in 1892, and incorporated in New York state and headquartered in Boston. The company operated in sectors including healthcare, aviation, power, renewable energ ...
, the spread is often just a few pennies – much less than 1% of the price. For illiquid stocks, the spread can be much larger, amounting to a few percent of the trading price.
See also
*
Funding liquidity Funding liquidity is the availability of credit to finance the purchase of financial assets. The International Monetary Fund (IMF) defines funding liquidity as "the ability of a solvent institution to make agreed-upon payments in a timely fashion".
...
*
Market impact
In financial markets, market impact is the effect that a market participant has when it buys or sells an asset. It is the extent to which the buying or selling moves the price against the buyer or seller, i.e., upward when buying and downward when ...
References
Sources
"Liquidity: Finance in motion or evaporation" lecture by Michael Mainelli at
Gresham College
Gresham College is an institution of higher learning located at Barnard's Inn Hall off Holborn in Central London, England. It does not enroll students or award degrees. It was founded in 1596 under the will of Sir Thomas Gresham, and hosts ove ...
, 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 marketsby David Marshall and Robert Steigerwald (Federal Reserve Bank of Chicago)
Financial market utilities and the challenge of just-in-time liquidityby 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, .
*
{{DEFAULTSORT:Market Liquidity
Financial markets