Lesson 15: Liquidity

Gold

I use this image whenever I can. Just look at that sheen.

Imagine I come up to you and allow you a choice. Because I am a very generous, benevolent man I offer you either $100,000 in cash or gold bars worth $100,000. Which offer makes more sense to choose? The time value of money is not relevant in this instance as you will gain the assets at the same time.  Your gut may be leaning towards the cash. Ignoring the obvious allure of shiny gold, you may realize that gold isn’t that useful in terms of purchasing everyday goods and services. You may also realize that there are additional steps you will have to take to turn that gold into cash such as finding someone to buy that gold and give you cash in return.  This concept of transforming an asset (gold in this case) into cash is known as liquidity.

Key Points

  • Liquidity is defined as the ease in which an investment can be converted into cash with little to no loss of value.
  • Cash is the most liquid of all assets.
  • There is a hierarchy of liquidity when it comes to investments.
  • Markets play a key role in maintaining liquidity of investments.
  • Imbalanced markets can create liquidity problems.

What is Liquidity?

Liquidity is a characteristic of investments that describes how easily an investment can be quickly converted into cash with little to no lose in value. An investment which cannot be easily converted into cash or can only be converted to cash quickly with loss of value is said to be illiquid.  Though there is no established scale for measuring liquidity, a rough hierarchy can be built to compare different assets’ liquidity.

Cash is the Most Liquid Asset

River

The other “liquid asset”. Image courtesy of nature.org.

Cash is commonly like water in the world of finance. When valuing a company you may create financial models that measure future cash “flows”. Keeping with this comparison cash is the most “liquid” asset and thus is used as the basis for measuring liquidity

Why is the cash the most liquid asset? As I referenced to earlier if you walked into a shop or a restaurant and tried to pay with gold coins or a very valuable, rare painting, you may find yourself in an undesirable situation. Cash is the most liquid because it is the currency we use in everyday commerce.  If we instead used shells or cigarettes (both of which have been used as currencies in certain economies) as currency, the shells/cigarettes would be the most liquid asset you could possess.

What is the Hierarchy of Liquid Assets?

As we established above cash is the most liquid of all investments. The diagram below places other common investments along a rough scale of liquidity.

 

tri2
What Links Liquidity and Markets ?

These rankings beg the question “What determines whether an investment is liquid or illiquid?” The answer is really simple: Is there a well functioning market that puts buyers and sellers together to exchange the investments?

Near the top of the liquidity scale are assets that have large exchanges and are traded frequently (stocks, bond, ETFs). Further down the scale you come across assets that are not as widely traded or are highly specialized (financial derivatives, commodities, real estate). The least liquid assets are incredibly specialized or lack a centralized market (rare art, antiques, cars).

The presence of a market is not enough to make an asset liquid. The market must be efficient with relatively equal supply and demand. Said differently the market cannot be buyer or seller dominated. In this instance the investment may be sold at a high premium or a deep discount due to the abundance or scarcity of the investment.

Gold diamond

A gold diamond…close enough. Image courtesy of vivalididiamonds.

For example let’s assume there is a new type of gold discovered called “diamond gold”. Furthermore let’s assume that Diamond Gold Inc. is the sole supplier (seller) on the diamond gold market.  In this instance because Diamond Gold Inc. controls the supply of diamond gold it can charge a high price for the diamond gold, reducing the trading of diamond gold, and rendering it illiquid.

What happens to an asset’s liquidity if the market is dominated by people wanting to sell a certain type of asset? This question was answered in the real estate crash that accompanied the 2008 Recession.

Liquidity and Risk: A Lesson from the 2008 Recession?

Foreclosure

Now imagine an entire street full of these things. Image courtesy of vinafengshui.

While the 2008 Recession is deserving of its own website, let’s look at a small aspect of the 2008 recession: the real estate market.  When home values began to plummet home owners were desperate to try to get rid of the “hot potato” that was their
homes.This flooded the real estate with homes (many of which were previously foreclosed on). As simple economics would dictate with this flood of supply buyers could pay a deep discount for homes that under normal circumstance would have a much higher value.  

Remember the aspect of liquidity in which the asset is converted “without significant loss of value”? In a market flooded with supply this tenant is violated as assets can only be sold at significantly lower cash values. Though this is a simplification of the complex 2008 Recession the effect of illiquidity was easily noticeable in the pummeled real estate market of the time.

Definitions

  1. Liquidity: a characteristic of investments that describes how easily an investment can be quickly converted into cash with little to no loss of value
  2. Illiquid: a characteristic of an investment in which an investment cannot quickly or easily be converted into cash without loss of value
  3. Currency: a medium of exchange that has value and is used to purchase goods and services

Further Reading

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