The term liquidity is used
in various ways, all relating to
availability of, access to, or convertibility into cash.
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.
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.
An asset is said to be liquid if the market
for that asset is liquid.
The common theme in all three contexts is cash. A
corporation 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.
The liquidity of an institution depends on:
the institution's short-term need for cash;
cash on hand;
available lines of credit;
the liquidity of the institution's assets;
the institution's reputation in the
marketplace—how willing will counterparties be to transact trades with
or lend to the institution?
The liquidity of a market is often measured as the size of
its bid-ask spread, but this is an
imperfect metric at best.
More generally, Kyle (1985) identifies
three components of market liquidity:
the bid-ask spread;
depth is the
volume of transactions necessary to move prices;
the speed with which prices return to equilibrium following a large trade.
identifies a fourth component, which he calls
diversity. 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 liquidity black
holes. These are conditions where liquidity dries up,
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.
Examples of assets that tend to be liquid include foreign
exchange, stocks traded on the New York Stock Exchange or
bonds. Assets that are often illiquid include limited partnerships, thinly
traded bonds or real estate.