Liquidity (Or Market Liquidity) Essay

Cheap Custom Writing Service

Liquidity (or market liquidity) is the ease with which financial  market   participants   can  quickly  execute large trades without significantly impacting prices. An investor buys a financial instrument in a liquid market with confidence that there will be a ready prospect for its sale in the future. In the absence of market liquidity, an investor faces liquidity risk or the financial risk that an asset cannot easily be sold. A financial instrument that trades in a highly liquid market carries less liquidity risk, which both encourages greater investment and reduces the funding costs of the issuer.

Another  benefit of market  liquidity is rapid price discovery. New information  is an important driver of market  trading.  Dispersed  beliefs of traders  on an asset’s equilibrium  price  as a result  of any new information  may converge toward a consensus more quickly in a more liquid market. Alternatively, on liquid stock exchanges characterized  by the participation of many uninformed  liquidity or noise traders, informed speculators may be able to trade more profitably on private information, which, in turn, increases both the returns  to monitoring  management  and the informational  content  on management  performance in a stock’s price.

The benefits of market liquidity may also be seen as a public good that may justify a role for government in its maintenance. The significance of sound financial markets for stable economic growth and the reliance on them to guide and transmit  monetary policy have also led to  increased  concern  for the  maintenance of market  liquidity.  Illiquidity  in  financial  markets may have serious consequences  for overall economic activity. With responsibility for the safety and soundness of financial systems and in their role as lender of last resort, central banks are critical to the provision of liquidity to illiquid markets.

There is no one universally accepted  measure  of market liquidity. The degree of liquidity found in any market is most commonly assessed in terms of tightness, depth,  and  resiliency. Tightness  refers  to  the relative divergence of trade prices from mean prices reflected in bid-ask spreads or the market’s capacity to align supply and demand  at minimal cost. Depth reflects the number of trades or the size of trades that can be completed  without  impacting  current  prices. Alternatively, depth may be reflected in the turnover or trading volume in a market, which is a commonly used measure of liquidity. It is generally assumed that tightness and depth are positively correlated with narrower spreads found in more actively traded markets. A third common measure of market liquidity is resiliency or the speed at which prices and order volume return to their equilibrium values subsequent to a large trade.

The determinants of market  liquidity in any one market can result from the interaction  of various factors  including  financial  instrument design,  market microstructure, and the behavior of market  participants. The design of financial instruments determines their  substitutability,  which,  if high,  may  result  in higher concentration and measured  liquidity in one among the alternatives. Such preferences would then induce  investors  preferring  greater  liquidity to also invest in that one financial product. Alternatively, substitutability  may lead to greater liquidity for all as one substitutable  product  may more easily serve as a hedge for another.

Market microstructure can also significantly influence market liquidity. One distinction is between trade execution  systems: auction-agency  or  order-driven markets,  such  as most  organized  stock  exchanges, and quote-driven  or dealer markets, such as the foreign exchange market. Price discovery is believed to be enhanced  by the  former  while the  latter  allows faster execution of trades but reserves for the dealer a monopoly  on information  about  order  flow. Such systems vary around  the  world and  are not  necessarily determined by the particular  financial instrument  traded.  They are often the result  of historical or  institutional legacy. In  general,  market  liquidity is enhanced  by the existence of competitive  trading structures  for market  makers  and  participants.  For example, the ability to trade a stock on both an organized  exchange  and  over-the-counter (OTC)  or on more than one exchange increases the market liquidity for  the  stock.  Competition between  exchanges and markets can increase liquidity by increasing trading   efficiency.  Other   microstructure  elements can also affect market  liquidity. For example, lower transaction  costs and the standardization of trading and settlement  practices  appear  to increase  market liquidity.  Finally, market  participant   behavior  and composition are other factors affecting market liquidity. An increase in investors’ risk aversion reduces it as does the  loss of confidence  in their  forecasts  of future prices. Greater heterogeneity of financial market participants,  including cross-border  participants, increases liquidity through  the enhanced prospect of matching buyers and sellers in the market.

Although greater market liquidity is generally considered a public and private good, there is also the possibility of excess liquidity. Financial crises often follow the collapse of asset price bubbles that are generally believed to  be created  by excess liquidity resulting from the expansion of credit in one or more markets. Following the collapse of a bubble, credit tightens as the value of bank assets falls and liquidity may evaporate  in  markets  throughout the  financial  system. Ultimately, the liquidity of financial instruments in a market depends upon the confidence of market participants in their ability to assess their value and trade them at will. Excessive confidence can lead to excess liquidity and asset bubbles. The loss of investor confidence can lead to illiquidity and the collapse of markets. In such cases financial markets  look to central banks to restore liquidity.

 

Bibliography:  

  1. Allen and D. Gale, “An Introduction to Financial Crises,” Wharton Financial Institutions  Center, Working  Paper No. 07-20 (2007);
  2. Bank for International Settlements, Market Liquidity: Research Findings and Selected Policy Implications (1999);
  3. Fleming, “Measuring Treasury Market  Liquidity,” Federal Reserve Bank  of New York Economic Policy Review (2003);
  4. Kristian Hartelius, Kenichiro Kashiwase, and  Laura E. Kodres, Emerging Market Spread Compression: Is It Real or Is It Liquidity? (International Monetary Fund, Monetary and Capital Markets  Department, 2008);
  5. Holmström and J. Tirole, “Market  Liquidity  and  Performance   Monitoring,”  Journal of Political Economy (1993);
  6. Jennifer Huang and Jiang Wang, Market Liquidity, Asset Prices and Welfare (National Bureau of Economic Research, 2008);
  7. Kyle, “Continuous Auctions and Insider  Trading,” Econometrica (1985);
  8. Marès, “Market Liquidity and the Role of Public Policy,” BIS Papers No. 12 (2002);
  9. Josephine Berry Slater, Living in a Bubble: Credit, Debt & Crisis (Mute Pub, 2007).

This example Liquidity (Or Market Liquidity) Essay is published for educational and informational purposes only. If you need a custom essay or research paper on this topic please use our writing services. EssayEmpire.com offers reliable custom essay writing services that can help you to receive high grades and impress your professors with the quality of each essay or research paper you hand in.

See also:

ORDER HIGH QUALITY CUSTOM PAPER


Always on-time

Plagiarism-Free

100% Confidentiality

Special offer!

GET 10% OFF WITH 24START DISCOUNT CODE