Liquidity

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Liquidity</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#liquidity">liquidity</a><p class="word_list"> <a href="#liquidity black holes">liquidity black hole</a><p class="word_list"> <a href="#depth">market depth</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <a href="#diversity">market diversity</a><p class="word_list"> <a href="#resiliency">market resiliency</a><p class="word_list"> <a href="#tightness">market tightness</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">The term <b><a name="liquidity">liquidity</a></b> is used in various ways<strong style="font-weight: 400">, all relating to availability of, access to, or convertibility into cash.</strong></p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10">An institution is said to have liquidity if it can easily meet its needs for cash either because it has cash on hand or can otherwise raise or borrow cash.<p class="bullet_line_space"> <img border="0" src="../images/bullet.gif" width="20" height="10">A market is said to be liquid if the instruments it trades can easily be bought or sold in quantity with little impact on market prices.<p class="bullet_line_space"> <img border="0" src="../images/bullet.gif" width="20" height="10">An asset is said to be liquid if the market for that asset is liquid. <p class="body">The common theme in all three contexts is cash. A <a href="../articles/corporation.htm">corporation</a> is liquid if it has ready access to cash. A market is liquid if participants can easily convert positions into cash. An asset is liquid if it can easily be converted to cash.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="165" align="left" id="table6"> <tr> <td width="160"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td> <td width="11"> </td> </tr> </table> <p class="body">The liquidity of an institution depends on: </p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10">the institution's short-term need for cash;<p class="bullet_line_space"> <img border="0" src="../images/bullet.gif" width="20" height="10">cash on hand;<p class="bullet_line_space"> <img border="0" src="../images/bullet.gif" width="20" height="10">available lines of credit;<p class="bullet_line_space"> <img border="0" src="../images/bullet.gif" width="20" height="10">the liquidity of the institution's assets; <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10">the institution's reputation in the marketplace—how willing will counterparties be to transact trades with or lend to the institution? <p class="body">The liquidity of a market is often measured as the size of its <a href="../articles/spreads.htm">bid-ask spread</a>, but this is an imperfect <a href="../articles/risk_metric_and_risk_measure.htm">metric</a> at best. More generally, Kyle (<a href="#Kyle, A. S. (1985)">1985</a>) identifies three components of market liquidity:</p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="tightness">tightness</a></b> is the bid-ask spread;</p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="depth">depth</a></b> is the volume of transactions necessary to move prices;</p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="resiliency">resiliency</a></b> is the speed with which prices return to equilibrium following a large trade.</p> <p class="body">Persaud (<a href="#Persaud, A. C. (2001)">2001</a>) identifies a fourth component, which he calls <b><a name="diversity"> diversity</a></b>. This is simply the degree of diversity among market participants in their market views and desired trades. Persaud argues that lack of diversity can lead to <b><a name="liquidity black holes">liquidity black holes</a></b>. These are conditions where liquidity dries up<strong style="font-weight: 400">, and a decline (or increase) in prices brings out more sellers (or buyers), further exasperating the price move. This is the exact opposite of what would be expected in a regularly functioning market, where, a price decline would bring out bargain hunters. Perhaps the classic example of a liquidity black hole is the 1987 stock market crash.</strong></p> <p class="body">Examples of assets that tend to be liquid include foreign exchange, <a href="../articles/common_stock.htm">stocks</a> traded on the New York Stock Exchange or <a href="../articles/treasury_securities.htm">on-the-run</a> <a href="../articles/treasury_note_and_bond.htm">Treasury bonds</a>. Assets that are often illiquid include limited partnerships, thinly traded <a href="../articles/coupon_bond.htm">bonds</a> or real estate. </p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table7"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table8"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/asset_liability_management.htm">asset-liability management</a> <strong style="font-weight: 400">Techniques for protecting a firm's solvency in the context of accrual accounting.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/capital_allocation.htm">capital allocation</a> A process of choosing what ventures, deals or trades to engage in, usually based upon some cost or risk-return analysis.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/fixed_income_term_structure.htm">fixed income term structure</a> Refers collectively to a spot curve, forward curve, discount curve, yield curve or any other curve that describes the time value of money at a particulate point in time.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/interest_rate_spreads.htm">interest rate spreads</a> An overview.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/leverage.htm">leverage</a> Debt financing or anything that can similarly magnify the risk and reward of an investment.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/liquidity_risk.htm">liquidity risk</a> Risk due to uncertain liquidity.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/spreads.htm">spreads</a> An overview.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_1.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%">  <p class="ad_legend" style="margin-left: 0; margin-bottom:2"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font color="#000000">Ads by Contingency Analysis</font></a></p> <p style="margin-top: 0; margin-bottom: 0"> <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=iframe" style="margin: 0px; padding: 0px; border-width: 0px" width="336" height="265" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" name="I1"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=336x265;setID=82436"> <img src="http://servedbyadbutler.com/adserve.ibs/;ID=147917;size=336x265;setID=82436;type=img" border="0" height="265" width="336" alt=""></a> </noscript><![endif]></iframe>   </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table9"> <tr> <td width="100%"> <p class="explanatory_text">Books on liquidity are rare, but Persaud's (<a target="_blank" href="http://www.riskbook.com/link/persaud_avinash_(2003).htm">2003</a>) edited collection is excellent. Harris (<a target="_blank" href="http://www.riskbook.com/link/harris_larry_(2003).htm">2003</a>) is an outstanding text on all aspects of trading. It discusses liquidity in depth. Schwartz and Francioni (<a target="_blank" href="http://www.riskbook.com/link/schwartz_and_francioni_(2004).htm">2004</a>) is the essential text on liquidity in equity markets.</p> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table10"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap369"> <area target="_blank" href="http://www.riskbook.com/link/persaud_avinash_(2003).htm" shape="rect" coords="0, 0, 84, 124"> </map> <img border="0" src="../images/book_persaud_avinash_(2003)_125.gif" usemap="#FPMap369" width="85" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table11"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/persaud_avinash_(2003).htm">Liquidity Black Holes</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Avinash D. Persaud (Ed.)</b></td> </tr> <tr> <td width="10%"><map name="FPMap367"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_5.gif" usemap="#FPMap367" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"><map name="FPMap368"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_2.gif" usemap="#FPMap368" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2003</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap366"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/persaud_avinash_(2003).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap366" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table12"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap375"> <area target="_blank" href="http://www.riskbook.com/link/harris_larry_(2003).htm" shape="rect" coords="0, 0, 85, 124"> </map> <img border="0" src="../images/book_harris_larry_(2003)_125.gif" usemap="#FPMap375" width="86" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table13"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/harris_larry_(2003).htm"> Trading and Exchanges</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Larry Harris</b></td> </tr> <tr> <td width="10%"><map name="FPMap379"> <area target="_blank" 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border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table14"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap378"> <area target="_blank" href="http://www.riskbook.com/link/schwartz_and_francioni_(2004).htm" shape="rect" coords="0, 0, 82, 124"> </map> <img border="0" src="../images/book_schwartz_and_francioni_(2004)_125.gif" usemap="#FPMap378" width="83" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table15"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/schwartz_and_francioni_(2004).htm"> Equity Markets in Action</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Robert Schwartz and Reto Francioni</b></td> </tr> <tr> <td width="10%"><map name="FPMap373"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_6.gif" usemap="#FPMap379" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"><map name="FPMap374"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_1.gif" usemap="#FPMap380" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2004</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap377"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/schwartz_and_francioni_(2004).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap377" width="146" height="20"></td> </tr> </table> </td> </tr> </table> </td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Papers</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table16"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_paper_glossary.gif" width="21" height="15"><a name="Kyle, A. 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