Market liquidity

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(Redirected from Liquidity)

Market liquidity is a business or economics term that refers to the ability to quickly buy or sell a particular item without causing a significant movement in the price. The term is usually shortened to liquidity.

A liquid asset has four features. It can be sold (1) rapidly, (2) without advertising costs, (3) at a very low transaction cost, (4) anywhere. The supremely liquid asset is a national currency certificate in the country of its origin, assuming that the currency is not depreciating extremely rapidly.

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 is considered deeply liquid if there are ready and willing buyers and sellers in large quantities. This is related to a deep market, where orders can not strongly influence prices.

The liquidity of a product can be measured as how often it's bought and sold. For stocks this is known as the volume of trades ([1]).

Often investments in liquid markets such as the stock exchange are considered to be more desirable than investments that are considered relatively illiquid, like real estate. This is because the forced sale or purchase of an item in an illiquid market may be at a disadvantageous price. Because assets that have liquid secondary markets are more advantageous to their owners, buyers of such assets are willing to pay a higher price for the asset than for comparable assets without a liquid secondary market. This 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 contribute to the liquidity of a market. One of the usual objections to a Tobin tax is precisely that it will discourage speculation on currencies, which will lessen the liquidity of foreign exchange markets, increasing their volatility. It is for this reason that market makers and professional traders are exempted in the UK from the 0.5% ad valorem tax on share purchases.

The risk of illiquidity need not apply only to individual investments: whole portfolios are subject to liquidity 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.

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.

[edit] 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 provide the bulk of funding (liabilities) in traditional commercial banks, and the loan portfolio represents the bulk of assets. 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 withdrawls 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. Most banks are subject to legally-mandated reserve requirements intended to help banks avoid liquidity crises.