Everything about Market Liquidity totally explained
Market liquidity is a
business,
economics or
investment term that refers to an asset's ability to be easily converted through an act of buying or selling without causing a significant movement in the
price and with minimum loss of value.
An act of exchange of a less liquid asset with a more liquid asset is called
liquidation.
Liquidity also refers both to that quality of a business which enables it to meet its payment obligations, in terms of possessing sufficient liquid assets; and to such assets themselves.
Summary
A liquid asset has some or more of the following features. It can be sold (1) rapidly, (2) with minimal loss of value, (3) anytime within market hours. The essential characteristic of a
liquid market is that there are ready and willing buyers and sellers at all times. An elegant definition of liquidity is also the probability that the next trade is executed at a price equal to the last one. A market may be considered
deeply liquid if there are ready and willing buyers and sellers in large quantities. This is related to a
market depth, where sometimes orders can't strongly influence prices.
The liquidity of a product can be measured as how often it's bought and sold; this is known as
volume. Often
investments in liquid markets such as the
stock exchange or
futures markets are considered to be more liquid than investments such as
real estate, based on their ability to be converted quickly. Some assets with liquid secondary markets may be more advantageous to own, are willing to pay a higher price for the asset than for comparable assets 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 treasuries with the same term remaining until maturity. Buyers know that other investors are not willing to buy off-the-run so the newly issued bonds have a lower yield and higher price.
Speculators and
market makers are key contributors to the liquidity of a market, or asset. Speculators and market makers are individuals or institutions that seek to profit from anticipated increases or decreases in a particular market price. By doing this, they provide the capital needed to facilitate the liquidity. The risk of illiquidity need 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.
Futures
In the
futures markets, there's no assurance that a liquid market may exist for offsetting a commodity contract at all times. Some futures 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.
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 doesn't contribute to public
price discovery.
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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 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.
Deposit accounts represent the primary funding (
liabilities) in traditional commercial banks, and the
loan portfolio represents the primary asset. 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, 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. Most banks are subject to legally-mandated reserve requirements intended to help banks avoid a
liquidity crisis.
Business
In business, the term refers to a company's ability to meet its obligation when and in the event they fall due. If a firm is unable to meet its obligation in time, the company is in danger of insolvency. Therefore, heavy weight is put in finance planning by the controlling staff in order to register all potential shortages in funds. If there's a shortage, the Treasury will be informed in order to be prepared to raise capital for the next business period. If a shortage of funds is registered too late and the funds are insufficient, banks may reject lending a company capital, and in consequence
bankruptcy might be inescapable.
In business, merchants often have
liquidation sales, in which inventories are sold at discount to raise cash or to get rid of inventory more quickly.
Further Information
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