What it means
Liquidity is about how easily you can turn an asset into cash without losing value. In a liquid market, such as the market for major currencies or shares in large listed companies, you can usually sell in seconds at a price very near the last one quoted.
Three features define a liquid market. First, there are many participants, so there is always someone willing to take the other side of a trade.
Second, the gap between the price buyers will pay and the price sellers will accept, called the bid-ask spread, is small, and third, trading volume is high enough that large orders can be absorbed without pushing the price sharply up or down. Liquidity matters because it lowers the cost of dealing and the risk of being stuck.
An investor in a liquid market can change their mind cheaply, a company can raise or invest cash without delay, and prices more accurately reflect what the market thinks an asset is worth. In an illiquid market, such as the market for a private business or a specialist property, selling may take months and may require a large discount.
Liquidity is not constant. It can disappear in a crisis, when everyone wants to sell and few want to buy, and a market that seemed liquid in calm periods can become hard to trade in.
Some markets are liquid only at certain times of day, or only for small trades. Treasury and investment teams therefore test liquidity before relying on it.
They look at average daily volume, the typical spread, and how much of a position they could sell in a day without moving the price, and they hold more cash if the assets they own are hard to sell. Regulators often ask banks and funds to show the same analysis, known as a liquidity stress test.
In practice
Real-world examples.
Example
A corporate treasurer needs to convert $5,000,000 into euros to pay a supplier. Because the major currency market is liquid, the trade is done within minutes at a price very close to the quoted rate. The treasurer does not need to ask for a special quote or split the order into smaller pieces.
Example
An investor sells 2,000 shares in a large listed company during the trading day. The order is filled in seconds at almost the last traded price, and the spread costs only a few cents per share. Because dealing costs so little, the investor can adjust the portfolio whenever circumstances change.
Example
A fund manager wants to sell a large holding in a small company. The shares trade only a few thousand a day, so the manager spreads the sale over several weeks to avoid pushing the price down. Even so, the average sale price ends up below the price quoted on the day the decision was made.
Formula
Calculation
Bid-ask spread as a percentage = (ask price - bid price) / midpoint price x 100.
Suppose a share is quoted with a bid of $49.98 and an ask of $50.02. The spread = 50.02 - 49.98 = $0.04. The midpoint = (49.98 + 50.02) / 2 = $50.00. The spread as a percentage = 0.04 / 50.00 x 100 = 0.08%, which is very small and typical of a liquid market. A share quoted at $9.00 bid and $9.60 ask has a spread of 0.60 / 9.30 x 100 = about 6.5%, a sign of poor liquidity.Case study
Seen in the real world.
Eastmere Foods is an illustrative, fictional company that had $8,000,000 of surplus cash and wanted to earn a return for six months. Its treasurer compared investing in short-term government securities with buying shares in a thinly traded smaller company.
The government securities could be sold on any day at a spread of a fraction of a cent per dollar, while the small-company shares had a 5% spread and traded only a few hundred thousand dollars a day. The treasurer concluded that selling a large position in the shares quickly could cost hundreds of thousands of dollars.
In this illustrative case, Eastmere chose the government securities, and when it needed $3,000,000 early for a supplier deal it sold the securities within an hour without any noticeable loss. The treasurer noted that liquidity had a value of its own. She now keeps a policy that at least half of surplus cash must be held in assets that can be sold within a day.
Watch out
Common mistakes.
- Assuming a market is liquid because the price is quoted, when quoted prices may not be available for large amounts.
- Ignoring that liquidity can vanish in a crisis, when spreads widen and buyers step back.
- Equating liquid with safe, when a liquid asset can still fall sharply in value.
Questions
People also ask.
How do I measure liquidity?
Look at the bid-ask spread, the average daily trading volume and how much the price moves when you trade a large amount.
Why do illiquid assets offer higher returns?
Investors demand extra compensation for the risk of being unable to sell quickly, known as a liquidity premium.
Are all listed shares liquid?
No, small companies may trade rarely, so the spread and price impact can be large.
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