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.
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 cannot strongly influence prices.
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, 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 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 (See Here).
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 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.
Accounting liquidity (liquidity) is a measure of the ability of a debtor to pay their debts as and when they fall due. It is usually expressed as
a ratio or a percentage of current liabilities.
Calculating liquidity:
For a corporation with a published balance sheet there are various ratios used to calculate a measure of liquidity. These include the following:
- the current ratio, which is the simplest measure and is calculated by dividing the total current assets by the total current
liabilities. A value of over * the quick ratio - calculated by deducting inventories and prepayments from current assets and then
dividing by current liabilities - gives a measure of the ability to meet current liabilities from assets that can be readily sold.
A better way for a trading corporation to meet liabilities is from cash flows, rather than through asset sales, so;
- the operating cash flow ratio can be calculated by dividing the operating cash flow by current liabilities. This indicates the
ability to service current debt from current income, rather than through asset sales.
Understanding the ratios:
For different industries and differing legal systems the use of differing ratios and results would be appropriate. For example, in
a country with a legal system that gives a slow or uncertain result a higher level of liquidity would be appropriate to cover the
uncertainty related to the valuation of assets. A manufacturer with stable cash flows may find a lower quick ratio appropriate than
an Internet-based start up corporation.
Liquidity in banking:
Liquidity is a prime concern in a banking environment and a shortage of liquidity has often been a trigger for bank failures.
Holding assets in a highly liquid form tends to reduce the income from that asset (cash, for example, is the most liquid asset
of all but pays no interest) so banks will try to reduce liquid assets as far as possible. However, a bank without sufficient
liquidity to meet the demands of their depositors risks experiencing a bank run. The result is that most banks now try to forecast
their liquidity requirements and maintain emergency standby credit lines at other banks. Banking regulators also view liquidity
as a major concern.
See Also:
History of Money,
Money supply,
Credit Money,
Market liquidity,
Top 1-25 Billionaires,
25-50 Top Billionaires,
Warren Buffett,
Carlos Slim Helu & family,
William Gates III,
Handling Your Money
References:
