Liquidity 101: A Quick Breakdown of What It means

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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?

the word Liquidity embedded on a button that a man is pointing at


 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.


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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