DEFINITION of Liquidity
Liquidity is a market’s feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset’s price.
WHAT IT IS IN ESSENCE
It can also refer to the facility of converting an asset to cash quickly and easily.
It is about how big the balance is between the speed of the sale and the price it can be sold for.
In a market, the tradeoff is mild: selling quickly will not reduce the price much.
In a relatively illiquid market, selling it quickly will require cutting its price by some amount.
Say an asset or group of assets are heavily trading on the market. Liquidity will generally be high as it will be much easier to find a buyer (or seller) for that asset.
That makes for a safer investment, as a trader can exit their position quickly without major impact on the asset’s price.
Money, or cash, is the most liquid asset. Because it can be “sold” for goods and services instantly with no loss of value. There is no wait for a suitable buyer of the cash.
There is no trade-off between speed and value. It can be used immediately to perform economic actions like buying, selling, or paying debt meeting immediate wants and needs.
A lack of this can add risk to an investment position, known as liquidity risk.
HOW TO USE
An act of exchanging a less liquid asset for a more liquid asset is called liquidation, often the less liquid asset for cash, also known as selling it. An asset’s liquidity can change. For the same asset, its liquidity can change through time or between different markets, such as in different countries. The change is just based on the market liquidity for the asset at a particular time or in a particular country, etc.
When it comes to a product, it is measuring as how often it is bought and sold. In other words, either based on trade volume relative to shares outstanding or based on the bid-ask spread or transactions costs of trading.
Liquidity can be enhanced through share buy-backs or repurchases.