Question

• What is meant by liquidity in the markets and why is it important?
  • Note that we discussed three functions of liquidity: 1. Risk transfer, 2. Price efficiency (i.e., market equilibrium), and 3. Market performance (i.e., counterparty risk and systemic risk)

Answer 1

Liquidity means how quickly you can buy or sell the assets at its fair value. The term fair value is important because you should be able to sell the asset at a price closer to its value. Liquidity is very important in any market for an asset. High liquidity in the market helps in many ways. • In a market with high liquidity the transaction cost of the asset is very low. Take for example the bid -ask spread for high volume stocks in the US market. The difference is one cent. In a market with high liquidity, it is easy to determine the price of any asset because the recent price is available and that price can be used for transaction purpose. The number of buyers and sellers determine the price of the asset at its equilibrium level. It is very difficult to determine the asset value when the liquidity is low. For example, the real estate. When the asset being traded are highly liquid then the asset is priced efficiently and any new information would be very quickly adjusted in the price. Liquidity is also important because it helps in managing our risk exposure efficiently. Let say you having a portfolio of oil stocks but you are concerned about the internal conflicts in the middle east and concerned that oil prices may fall, so you can sell some of your portfolio in the market and reduce your exposure.