Market liquidity
Encyclopedia
In business
, economics
or investment
, market liquidity is an asset
's ability to be sold without causing a significant movement in the price
and with minimum loss of value. Money, or cash
, is the most liquid asset, and can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs.
An act of exchange of a less liquid asset with a more liquid asset is called liquidation.
Liquidity also refers both to a business's ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves.
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 the lack of a market in which it is regularly traded. 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 a 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 investment
s in liquid markets such as the stock market
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 market
s 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.
Speculators
and market maker
s 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.
.
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
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, 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 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. Lower costs generate stronger profits, more stability, and more confidence among depositors, investors, and regulators.
Business
A business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...
, economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
or investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
, market liquidity is an asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
's ability to be sold without causing a significant movement in the price
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
and with minimum loss of value. Money, or cash
Cash
In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...
, is the most liquid asset, and can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs.
An act of exchange of a less liquid asset with a more liquid asset is called liquidation.
Liquidity also refers both to a business's ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves.
Overview
A liquid asset has some or all 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 depthMarket depth
In finance, market depth is the size of an order needed to move the market a given amount. If the market is deep, a large order is needed to change the price. Market depth closely relates to the notion of liquidity, the ease to find a trading partner for a given order: a deep market is also a...
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 the lack of a market in which it is regularly traded. The mortgage-related assets which resulted in the subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
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 a 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 investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
s in liquid markets such as the stock market
Stock market
A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...
or futures markets are considered to be more liquid than investments such as real estate
Real estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
, based on their ability to be converted quickly. Some assets with liquid secondary market
Secondary market
The page applies to the finanical term; For the merchandising concept, see Aftermarket .The secondary market, also called aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold....
s 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.
Speculators
Speculation
In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...
and market maker
Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
s 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
Liquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
. Structural liquidity risk, sometimes called funding liquidity risk, is the risk associated with funding asset portfolios in the normal course of business
Ordinary course of business
In law, the ordinary course of business covers the usual transactions, customs and practices of a certain business and of a certain firm. This term is used particularly to judge the validity of certain transactions...
. 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
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
tries to influence the liquidity (supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
) 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 future 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 interestOpen interest
Open interest refers to the total number of derivative contracts, like futures and options, that have not been settled in the immediately previous time period for a specific underlying security...
.
There is also dark liquidity
Dark liquidity
In finance, dark pools of liquidity also referred to as dark liquidity or simply dark pools is trading volume or liquidity that is not openly available to the public. The bulk of these represent large trades by financial institutions that are offered away from public exchanges so that trades are...
, 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
Price discovery
The price discovery process is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers ....
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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. 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 banksInterbank lending market
The interbank lending market is a market in which banks extend loans to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate...
, borrowing from a central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
, such as the US Federal Reserve bank
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
, 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
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
. Most banks are subject to legally-mandated requirements intended to help banks avoid a liquidity crisis
Liquidity crisis
In financial economics, liquidity is a catch-all term that may refer to several different yet closely related concepts. Among other things, it may refer to Asset Market liquidity In financial economics, liquidity is a catch-all term that may refer to several different yet closely related...
.
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. Lower costs generate stronger profits, more stability, and more confidence among depositors, investors, and regulators.