Dynamics of Market Liquidity

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The liquidity of a financial market is its ability to buy or sell listed assets quickly, without having a major impact on prices. When a market is liquid, it is easy, fast and inexpensive to complete transactions. This feature is one of the essential qualities that must guarantee the stock exchanges.

Lack of liquidity in addition to an insufficient cash or indebtedness is the most common cause of insolvency in companies. In recent years, the liquidity of assets has become an important component of investment strategies.

Much of this interest comes from the liquidity problems of market absorption encountered by investors wishing to acquire or divest a significant amount of shares of small capitalization. Such negotiations sometimes lead to declines or excessive price increases.

Thus, fund managers, especially if they manage important lines capable of influencing the course of major portfolios, prefer the most liquid shares. This allows them to reduce their transaction costs, boost their portfolio (thus divestments and commitments can be made quickly). And to prevent the fund’s performance being disturbed by the lack of adequate consideration on the market.

Similarly, the treasurers of companies wishing to acquire securities under the short-term investments will focus on assets that are readily marketable and liquid.

The liquidity of a market depends on its organization but also of the asset. For example, the Eurodollar market is highly liquid, just like the stock market on Wall Street. Unlike the real estate market which is very illiquid, it bears no optimal market structure. The concept of liquidity is often linked with that of market depth.

Liquidity risk is the loss from the cost of liquidating a position. Typically, the illiquidity of the market manifests itself in the form of high transaction costs, a small number of transactions during the session or a higher price range.

It is clear that most markets experience some liquidity problems. Indeed, a number of markets may not have acceptable levels of liquidity throughout the session; but there are other markets that can boast of providing adequate liquidity to financial players.

However, even the liquidity of these major exchanges can not be guaranteed. Such markets are very liquid most of the time, but occasionally experience meetings of crisis (drying up of liquidity). It is possible to distinguish two types of liquidity risk.

The first is the normal liquidity risk which pertains to the increasing trade in markets deemed illiquid. The second type of liquidity risk is most insidious, it increases during market crises when the market loses its existing level of liquidity.

In economics, specifically in micro-economics, the quality of an economic subject is considered to be its ability to convert its assets into cash. Depending on the ease of converting an asset into cash, it is referred to as different liquidating.

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