Liquidity

Published Jan 5, 2023

Definition of Liquidity

Liquidity is defined as the ability of an asset to be quickly converted into cash without significantly affecting its market price. That means it describes how easily an asset (e.g., stocks, bonds, securities) can be bought or sold in the market. Assets that can be quickly converted into cash are said to be liquid, while those that cannot be easily converted into cash are said to be illiquid.

Example

To illustrate this, let’s look at two different assets: a stock and a house. A stock is an example of a liquid asset. You can buy or sell most publicly traded stocks in a matter of seconds. All you need to do is place an order with a broker (e.g. through an app like Robinhood), and the transaction is completed almost instantly.

On the other hand, a house is an example of an illiquid asset, because it cannot be quickly converted into cash. To sell a house, you need to first find a buyer, negotiate a price, and then wait for the sale to be finalized. This process can take weeks or even months. Plus, it can be hard to find potential buyers in the first place, because the number of people who are in the market for real estate is significantly smaller than those looking for less expensive (and more liquid assets).

Why Liquidity Matters

Liquidity is an important concept in financial economics because it affects the value of an asset. Relatively speaking, assets that are more liquid are usually more valuable because they can be quickly converted into cash. That means investors are willing to pay a premium for liquid assets because they know they can easily sell them if they need to. On the other hand, illiquid assets are usually less valuable because they cannot be quickly converted into cash. That means investors are less willing to pay a premium for them because they know they may have difficulty selling them if they need to.