Liquidity
Liquidity refers to how quickly and easily an asset can be converted to cash without significantly affecting its price. Cash is the most liquid asset, while real estate and collectibles are considered illiquid.
Exam Tip
Liquidity = ability to convert to cash quickly. Cash = most liquid. Real estate = illiquid. Illiquid assets often have higher expected returns.
What is Liquidity?
Liquidity measures how easily an asset can be bought or sold in the market without causing a significant change in its price. Highly liquid assets can be quickly converted to cash, while illiquid assets may take time to sell or require accepting a lower price.
Liquidity Spectrum
| Most Liquid | Moderately Liquid | Least Liquid |
|---|---|---|
| Cash | Corporate bonds | Real estate |
| Money market funds | Mutual funds | Private equity |
| T-Bills | Small-cap stocks | Art/collectibles |
| Large-cap stocks | ETFs | Partnership interests |
| Major currency | Restricted stock |
Factors Affecting Liquidity
| Factor | Impact |
|---|---|
| Trading Volume | Higher volume = more liquid |
| Bid-Ask Spread | Narrow spread = more liquid |
| Market Depth | More buyers/sellers = more liquid |
| Time to Sell | Faster sale = more liquid |
| Price Impact | Less impact = more liquid |
Measuring Liquidity
| Metric | What It Shows |
|---|---|
| Bid-Ask Spread | Cost of immediate transaction |
| Average Daily Volume | How often the asset trades |
| Days to Liquidate | Time needed to sell without price impact |
| Market Depth | Size of orders at various prices |
Liquidity and Investment Risk
| Aspect | Description |
|---|---|
| Liquidity Risk | Risk of not being able to sell when needed |
| Liquidity Premium | Extra return for holding illiquid assets |
| Fire Sale | Forced sale at below-market price due to illiquidity |
Examples of Liquidity
Highly Liquid:
- Apple stock (AAPL): Millions of shares trade daily
- US Treasury bills: Deep market, instant pricing
- Money market funds: Same-day redemption
Illiquid:
- Private company shares: No public market
- Real estate: Months to sell, high transaction costs
- Hedge fund interests: Lock-up periods, limited redemptions
Why Liquidity Matters
| Situation | Liquidity Importance |
|---|---|
| Emergency Fund | Needs high liquidity |
| Retirement (near) | Needs moderate liquidity |
| Long-term Investing | Can accept lower liquidity |
| Margin Trading | Needs liquid collateral |
Exam Alert
Liquidity = how fast you can convert to cash without price impact. Cash is MOST liquid. Real estate and alternatives are ILLIQUID. Illiquid investments often offer liquidity premiums (higher returns).
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Related Terms
Bid-Ask Spread
SecuritiesThe bid-ask spread is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask), representing a transaction cost and liquidity indicator.
Market Order
SecuritiesA market order is an instruction to buy or sell a security immediately at the best available current price, guaranteeing execution but not the price.