What is liquidity?

The efficiency or convenience with which a security or asset can be turned into quick cash without negatively impacting its market price is referred to as liquidity. Cash alone is the most liquid asset. As a result, the primary factor determining how well a market functions is the availability of funds for these conversions.

An asset may be converted back into cash more quickly and easily the more liquid it is. More time and money may be spent on less liquid assets.

There are two main reasons why it matters:

Price: When an asset is liquid, there are many buyers and sellers in the market. This competition helps keep the price stable. Less liquid assets, with fewer buyers and sellers, can have bigger price swings.

Slippage: This refers to the difference between the price you expect to pay for an asset and the price you actually pay. It's more common with illiquid assets because it can take time to find a buyer or seller at your desired price.

Examples

Liquid: Cash, savings accounts, government bonds, actively traded stocks (like Reliance or Infosys)

Less Liquid: Mutual funds (may take a few days to sell), corporate bonds (especially those issued by lesser-known companies), your car

Types

There are three main types to consider:

1. ‍Market Liquidity: Market liquidity is the degree to which assets can be purchased and sold at consistent, transparent prices in a market, such as the stock market of a nation or the real estate market of a city. Conversely, greater market liquidity is a feature of the stock market. A buyer's bid price (the price per share) and a seller's ask price (the price they are willing to accept) will be quite close to each other if an exchange has a significant volume of transaction that is not dominated by selling.
2. ‍Accounting Liquidity: This refers to a company's ability to pay its short-term debts. It's important for a company to have enough liquid assets on hand to cover its bills and keep operating. Accounting liquidity is measured by a number of ratios, each of which has a different definition of what constitutes liquid assets. These are used by investors and analysts to find companies with high liquidity. It is regarded as a depth measure as well.

Types of risks

There are different types of  risks to consider, each with its own challenges:

Market Risk: This is the risk that you won't find enough buyers or sellers for an asset in a particular market. It's like having a unique item at a garage sale - it might be valuable, but if there's no one interested, it's hard to sell quickly. This risk is common with stocks traded on smaller exchanges or assets with low trading volumes.

Funding Risk: This risk refers to the difficulty you might face when trying to access cash or borrow money when you need it. Imagine needing a loan urgently, but lenders are hesitant due to tight credit conditions. This can be a problem if you need to sell assets quickly to meet financial obligations.

Asset-Specific Risk: Some assets are less liquid than others. Think about a rare antique car compared to a commonly traded stock. The car might be valuable, but finding a buyer willing to pay your asking price could take time. Real estate and collectibles are also examples of assets with this type of risk.

Time Horizon Risk: This risk occurs when your investment has restrictions on how soon you can access your money. It's like putting your money in a locked box for a set period. Fixed deposits with early withdrawal penalties or investment funds with lock-in periods can pose this risk.

Event Risk: Sudden and unexpected events can disrupt markets and make it difficult to buy or sell assets. Imagine a major economic crisis causing a market crash. During such times, even typically liquid assets might become harder to trade.

Regulatory Risk: Changes in government rules or regulations can also affect it. For example, new restrictions on certain types of investments could make them less desirable to buyers, impacting them.

Conclusion

Liquidity is all about how quickly you can convert an asset into cash without losing its value. Cash is the most liquid asset, while stocks and other assets need to be easily convertible into cash. Understanding its different types and risks is essential for investors to manage their investments wisely.