What you will learn
- Explain liquidity and place common assets in order from easiest to hardest to sell
- Judge liquidity by looking at the bid-ask spread, market depth, and trading volume
- Separate market liquidity from the ability to borrow money for a position
- Explain why a hard-to-sell asset must offer investors a liquidity premium
You first met liquidity as one of the three jobs of a market, then used the bid-ask spread as a quick way to spot it. Now we can put those pieces together. Liquidity affects what a trade costs, how much risk you face, and what can happen during a financial crisis.
Liquidity Explained
Nice video created by Finance and Quant Society on what liquidity actually is. What before moving on! :))
What makes an asset liquid?
Liquidity describes how easily you can buy or sell an asset quickly, in a useful amount, without changing its price very much. A highly liquid asset turns into cash almost immediately at a fair price. An illiquid asset may take days or weeks to sell, and a fast sale may require a discount. Liquidity is about ease of trading. It does not mean the amount of cash that you or a company holds.
Key terms
- Liquidity
- The ease of buying or selling an asset quickly and in size without moving its price much.
- Illiquid
- Difficult to sell quickly at a fair price. A fast sale often requires a discount.
- Market depth
- The amount of buy and sell orders close to the current price. It shows how large a trade the market can handle.
- Liquidity premium
- The extra expected return that investors require for owning an asset that is hard to sell.
Some assets sell much faster than others
- Cash, Treasury bills, large company stocks, and major currencies are highly liquid. You can trade them almost immediately, usually with very small spreads.
- Many stocks in medium or small companies and many corporate bonds are moderately liquid. You can trade them, but the spread is usually wider.
- Real estate, ownership stakes in private companies, fine art, and securities that rarely trade are illiquid. A sale can take time and may require a lower price.
| Asset | Typical liquidity | Time needed for a fair-price sale |
|---|---|---|
| Cash and Treasury bills | Very high | Immediately |
| Stock in a large company | High | Seconds, usually with a tiny spread |
| Stock in a small company | Medium | Usually fast, but with a wider spread |
| A house or private business | Low | Weeks or months, often at a discount |
Three clues to liquidity
Start with the bid-ask spread. A narrow spread usually means better liquidity. Next, check market depth, which is the amount of orders waiting close to the current price. More depth allows the market to handle a larger trade before the price moves. Trading volume, the number of shares traded, offers a third clue. High volume usually appears alongside high liquidity. A narrow spread, a deep order book, and high volume all suggest that an asset is easy to trade.
Match each asset to its liquidity
Choose the typical level of liquidity for each asset.
Raise cash before Friday
It is Monday, and you need cash by Friday without accepting a large loss. You own stock in a large company, stock in a small company that rarely trades, and a rental house. Which asset should be easiest to sell quickly at a fair price?
The large company stock has the most liquidity. It offers the best chance of raising cash quickly without a large loss.Liquidity lets you sell without giving up much on price. During a crisis, that ability may disappear just when you need it.
Trading an asset versus funding a position
Professionals use two kinds of liquidity. Market liquidity is the ability to trade an asset easily. Funding liquidity is the ability to borrow the cash needed to hold a position. The difference may be hard to notice in calm markets. During a crisis, however, the two can make each other worse. Falling prices force investors to sell. More selling pushes prices down again, lenders become less willing to provide funding, and liquidity dries up. Investors therefore demand a liquidity premium, meaning extra expected return, before they agree to hold an asset that may be difficult to sell.
What is liquidity? (J.P. Morgan)
A nice video by JPMorgan to further strengthen the idea of liquidty (if you need it, liquidty can be a hard concept:))
What would make a lockup worthwhile?
Two investments have the same expected return. You can sell one at any time, but the other locks up your money for five years. Which would you prefer? What would the locked investment need to offer before you would choose it? Use the term liquidity premium.
Write an answer before comparing it with the model response.
Model answer
I would choose the investment that I could sell at any time because it gives me more flexibility. I would accept the five-year lockup only for a higher expected return. That added return would be the liquidity premium that compensates me for owning an asset that is hard to sell.
Liquidity affects both the cost and the risk of a trade. The next lesson introduces the firms that route trades and provide much of the market's liquidity: brokers, dealers, and market makers.