When it comes to financial terms, we’ll always hear the word
liquidity. For instance, they say that the foreign exchange market has the
highest level of liquidity among financial markets. And that’s true.
Now what do we really mean when we say liquidity? Which assets
are highly liquid?
In this article, we’re
going to breakdown what liquidity means for the financial markets. We will also
give you some idea which assets are considered good when it comes to liquidity.
What is liquidity?
The term “liquidity” refers to the ease at which assets can
be converted into cash. For one, stocks and bonds have high liquidity because they
can be easily converted into cold, harsh cash in a matter of days.
Read further, Picking Stocks: 4 Things to Consider
On the flip side, large assets like properties, plants, and
equipment cannot easily be turned into cash. It would usually take at least a
week or so before you can lay your hands down on cash.
Liquidity in the financial
industry
In finance, cash is considered to be the most liquid asset
for obvious reasons. Meanwhile, as mentioned above, assets like stocks and
bonds are also considered to be extremely liquid because you can quickly and
easily convert them into cash if you want to.
However, there are still exemptions that prove that rule. Some
investment assets can take a longer time before you can convert them into cash.
For instance, there are preferred or restricted shares. Such shares have
covenants that have the power to tell how and when the shares can be sold and
thus converted into cash.
Items like coins, stamps, and other collectibles are
considered to be less liquid than cash. Most of the time, the investor wants to
get the full value for the items. He may sell to another collector at full
value, but he’d have to wait longer for the right and willing buyer.
If he wants to liquidate the items quicker, he will have to
give it a discount since he would certainly have to have some help from a
broker or a dealer.
Land, real estate, or building rank as the least liquid
assets in the financial market since it would take at least several months
before one can sell them and thus convert them into cash.
Allocating Liquid Assets
Before you choose to invest in any asset, you must first
check how liquid that asset is. There will be times when you need to have quick
access to cold cash, and illiquid assets cannot be much of a help during such
times.
Of course, other than selling the asset, you can just obtain
cash by borrowing against an asset. That’s the case with bank that loan money
to companies. In exchange for the loan, the bank will make the company’s properties
as collateral to protect it from a default.
Market Liquidity
Market liquidity is all about the ability of the market to
facilitate the buying and selling of assets quickly and easily.
The market for a certain stock can be considered liquid is
you can buy and sell the shares quickly. Of course, the trade should have
little to no impact on the stock’s price. Company stocks that you trade on
major exchanges are normally considered liquid.
If an exchange sports high volume of trade, the bid price
and the ask price should be close to each other. Put simply, the buyer wouldn’t
have to pay more to buy the stock and thus would be able to liquidate it more
quickly.
As the spread between the bid and ask prices becomes wider,
the market then becomes more illiquid. This can amount to a few percentage
points of the trading price.
If you’re trading overseas, the time of the day might be
another crucial factor to consider. For instance, if you’re playing in the currency
markets, liquidity might be less for the euro if you choose to trade it during
the Asian trading hours instead of the European hours.
Conclusion
Liquidity is a very important concept to grasp. Before you
start investing in one of the financial markets, you should definitely study up
more on the importance of liquidity. This is very true when it comes to coming
up with a well-built portfolio that will answer to your needs in case you need
fast cash.
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