Liquidity and Market Microstructure

Overview

Liquidity is the ability of trader to easily buy or sell a security, without moving the price significantly in the process. Liquid assets can be turned into cash quickly and easily.

Liquidity is a key concept to understand when managing a portfolio. Illiquid assets are hard to trade. In some extreme cases, the asset is untradable. As an example, a large privately held company may have no liquidity, that is, it cannot be sold for cash, and the value to the owners is only the cash flows that it generates. As a general rule

Financial firms that have cash liabilities often need to manage their liquidity risk.

The liquidty of an instrument is driven by supply and demand, as well as the structure of the markets where it trades (so called market microstructure).

Supply and Demand

The ability to trade an asset for cash depends heavily on the supply and demand dynamics of the instrument. In particular, when the size of the asset of being sold is large with respect to the amount of the security demanded, the sale can only be accomplished after a sizable decrease in the current price.

When the amount of the security to be traded is small, it can be traded at the prevailing price.

Topics

• Market Impact describes the effects a particular trade may have on the current price of the traded asset.
• Market Microstructure is the study of how different markets structured and how that structure impacts the price dynamics in the market.
• Measuring Liquidity - Liquidity is a rather abstract concept and therefore, not necesarily easy to provide a single measure.