This article originally appeared in, co-authored with my good friend Ken Akoundi, President of ASPN Solutions. Ken and I will be speaking at the RiskHedge conference in NYC on July 8 on the topic of Liquidity Risk.

Market liquidity, when not taken for granted, is a complex topic that has no quick and easy explanation, measure or analysis. Without liquidity, a market cannot really exist, so most economic, valuation and risk models assume a high level of liquidity. Any other assumption is just too messy: how exactly does one go about modelling a market when one of its required characteristics – liquidity – is in short supply or non-existent?

Both the Wall Street Journal and Investopedia define liquidity similarly: the degree to which a security can be easily bought or sold without materially changing its price. Liquidity is not just the ability to buy or sell – liquidity is about the ability to do so without moving the market. That last bit means that to be truly liquid, a security needs plentiful buyers and sellers so anyone can transact at nearby prices, leading to one of the most common measures of liquidity: volume. But high volume alone does not mean you can always transact without moving the market: what if all that volume is dominated by buyers when there are few sellers – a strategy used by some hedge funds in frontier markets. Without plentiful sellers, just one buyer can and will move the market. The mirror image is also true. Size matters: small quantities can often be easily bought or sold and therefore some would describe the security as ‘liquid’, but the same security at larger quantities may not find a market at all.

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