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What is liquidity?
Liquidity describes the ability to buy or sell a security or an asset without the transaction having a significant effect on its price. Simply put, it describes the ease with which an asset can be converted into cash.
There are two main types of liquidity: market liquidity and accounting liquidity. Market liquidity refers to ease with which a market allows assets to be sold and bought at stable prices. Accounting liquidity is a measure of how easily a company or an individual can meet their financial obligations using the assets at their disposal.
Cash is the most liquid asset, and there are other assets that are very liquid. One of these is a certificate of deposit, which is somewhat less liquid due to the penalty that applies when you cash it ahead of the maturity date. Savings bonds are also fairly liquid, since you can easily sell them at a bank. Finally, bonds, stocks, options, and commodities are also relatively liquid given the ease of buying and selling them on the open market.
Liquidity has a slightly different meaning in the stock market, where shares in a company can be exchanged for cash. The liquidity of a stock describes how fast shares can be sold without a significant effect upon their price. This is determined by investors’ level of interest in the company and the location of the shares being traded. Usually, stocks that are traded on the main exchanges are considered more liquid, while stocks traded over the counter (OTC) are less liquid, with minimal volumes traded daily.
Alternatively, a company’s liquidity can also be judged by looking at the bid/ask spread. When it comes to very liquid stocks like General Electric or Microsoft, the spread is usually quite small, often less than one percent of the price. The spread is higher for illiquid stocks. It is therefore prudent for an investor to consider the liquidity of a stock when placing an order.
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An investor has saved $600,000 and bought a condo in Miami, betting that the red-hot real estate market would soar higher and increase the value of her investment. However, as a deepening financial crisis sweeps across the nation, she decides to sell the condo and put the funds into a safer investment. Given the general market uncertainty, it takes months to sell the condo, although the final sale price is $560,000, delivering the investor only a moderate loss.
We would describe the condo as a highly illiquid investment, given market conditions. Had the investor put her money into United States treasury bills — a highly liquid investment — she would have been able to have sold the assets almost immediately, although the potential for scoring a big return would have been much, much less.