Market liquidity
From Wikipedia, the free encyclopedia
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. Money, or cash on hand, is the most liquid asset.[1] An act of exchange of a less liquid asset with a more liquid asset is called liquidation. Liquidity also refers to a business' ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves.
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[edit] Overview
A liquid asset has some or more of the following features. It can be sold rapidly, with minimal loss of value, any time within market hours. The essential characteristic of a liquid market is that there are ready and willing buyers and sellers at all times. Another elegant definition of liquidity is 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 the concept of market depth that can be measured as the units that can be sold or bought for a given price impact. The opposite concept is that of market breadth measured as the price impact per unit of liquidity.
An illiquid asset is an asset which is not readily saleable due to uncertainty about its value or lacking a market in which it is regularly traded.[2] The mortgage related assets which resulted in the subprime mortgage crisis are examples of illiquid assets as their value is not readily determinable despite being secured by real property. Another example is an asset such as large block of stock, the sale of which affects the market value.
The liquidity of a product can be measured as how often it is 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, so buyers 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.[citation needed]
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.
[edit] Futures
In the futures markets, there is 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 does not contribute to public price discovery.[2]
[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. 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 assets (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, 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.
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, but at what cost? Lower costs generate stronger profits, more stability, and more confidence among depositors, investors, and regulators.
[edit] 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 is 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.
[edit] References
[edit] External links
- Market liquidity definition and explanation in clear terms
- "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)
