3 min
30-August-2024
Liquidity is the cornerstone of any financial market since it impacts every trading experience and the ability of investors to enter or exit positions. Moreover, it also impacts the risks that go with certain investments and the costs of trading. Hence, a thorough understanding of market liquidity’s meaning is required for both institutional and individual investors.
Trading in commodities leads to diversification and hedges against currency fluctuations and inflation. Commodities markets are known for their price transparency and high liquidity and offer ample opportunities for investors to book profits from demand and supply fluctuation dynamics globally.
An exotic pair’s characteristics are high volatility, low trading volumes, lesser liquidity, and broader bid-ask spreads. This makes them riskier for retail investors who refrain from trading in them. Hence, trading in an exotic forex pair needs prudent risk assessment and management owing to unpredictable and rapid fluctuations in price.
Thus, small-cap stock investments need thorough research on risk assessment. Even though they may yield substantial returns, the investor needs to be prepared for rapid price fluctuations and liquidity-related challenges.
If you are an investor and want to start your investment journey, you can visit the Bajaj Finserv Mutual Fund Platform to learn more about mutual fund schemes and SIPs. You can use the mutual fund calculator to calculate your financial goals. Calculate the returns on your investments in mutual funds to ensure your investment strategy aligns with your financial objectives.
What is market liquidity?
Market liquidity’s definition basically refers to the ease with which a security or asset is convertible into cash. Thus, any liquid asset can be easily and quickly converted into cash. Conversely, assets that are less liquid may take longer and usually incur higher expenses to convert into money.Example of market liquidity
Market liquidity varies significantly between different asset types and markets. Consider comparing a small city’s real estate market and the stock market of a large company listed on the National Stock Exchange (NSE).1. Real estate in a small city, say Coimbatore:
Trading volume and transactions are expected to be low, and the bid-ask spread will be wide. For instance, if the property’s listed price is Rs. 60 lakh, the highest offer could be Rs. 55 lakh. The price impact is high, and substantial price reductions are required to close the deal faster. The market depth is shallow, with few properties, buyers, and sellers. Significant price shifts are expected in single transactions.2. Stock market (Shares of XYZ)
The bid-ask spread is narrow. For instance, a bid at Rs. 2,400 may record an ask at Rs. 2,400.50. However, the volume of daily trading is quite high since millions of shares are traded. The market is deep, with large orders being executed with minimum price changes, whereas the price impact is low as large orders are executed with very low price shifts. The XYZ stock is highly liquid and facilitates cost-effective and fast trading, unlike real estate in Coimbatore, which is characterised by trading challenges and low liquidity without any notable price concessions.Why is market liquidity important?
The following are the reasons why market liquidity is important:- Facilitates efficient trading: Higher liquidity ensures that an investor can purchase or sell his assets faster and at fair prices to facilitate more efficient trading.
- Helps in risk management: Market liquidity enables an investor to exit his position when he faces a crisis or uncertainty, which helps manage risk.
- More attractive to investors: Highly liquid assets are usually more attractive to investors since they are more flexible and are easier to enter and exit.
Factors affecting market liquidity
Market liquidity is guided by several factors that include trading volume, the bid-ask spread, price impact, and market depth. High volumes of trading, narrow bid-ask spreads, deep markets having multiple sell and buy orders, and minimum price changes in large-volume transactions are all responsible for higher liquidity.1. Trading volume
Trading volume is the total number of contracts or shares traded for any specific asset during a pre-determined period, such as in a day. High trading volumes indicate a more liquid market with plenty of participants who transact easily and quickly. It reflects a robust investor confidence and interest in a given asset. A high volume of trading results in tighter bid-ask spreads and reduces transaction costs. Moreover, it enhances the market depth to allow the execution of large orders without any notable price changes. On the flip side, low volumes of trading suggest low liquidity and potential volatility in prices during trading.2. Bid-ask spread
The bid-ask spread may be defined as the difference between the bid or the highest price offered by a prospective buyer and the ask or lowest price a prospective seller will accept for the asset on sale. A narrow bid-ask spread reflects high liquidity in the market, suggesting that both sellers and buyers are agreeing on the price to make transactions more cost-effective and efficient. A broader bid-ask spread indicates lower liquidity, implying that few participants will be trading at current prices. The condition may result in enhanced price volatility and high transaction costs, which make it more difficult to quickly sell or buy the asset without altering its price.3. Volatility
Volatility is the degree to which an asset's price varies over time to indicate how quickly and how much prices can shift. High volatility implies that the cost of an investment can sharply fluctuate in a short span of time and reflects more risk and uncertainty. Conversely, low volatility is indicative of stable prices and lower risk. High volatility may reduce liquidity since it discourages trading due to unpredictable prices. Low volatility, conversely, enhances liquidity by creating a more predictable and stable trading environment that encourages more participants to transact.4. Market participants
Market participants are those institutions and individuals who are involved in active asset buying and selling in a given market and include retail and institutional investors, traders, and market makers. The diversity and presence of participants in the market enhance its liquidity and efficiency. Multiple participants with separate time horizons and strategies increase trading-related activities. Larger numbers of participants in the market lead to higher trading volumes and more constricted bid-ask spreads that improve liquidity. On the other hand, a dearth of participants may lead to wider spreads, lower trading activity, and decreased market liquidity.What are the most liquid markets?
The most liquid Indian markets are the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) for equities, the market for currency derivatives to trade in forex, and the market for government securities to trade in bonds. Such markets are characterised by high trading activities and heavy participation.1. Forex (major pairs)
Forex denotes the market for foreign exchange, and this is where currencies can be traded globally. The leading currency pairs comprise the most traded currencies globally, including the US Dollar, Euro, Japanese Yen, Pound Sterling, Australian and Canadian Dollar, and the Swiss Franc. The major pairs account for the lion’s share of the forex market’s trading volume and offer tight spreads, relatively lower transaction costs, and high liquidity owing to abundant market participants and constant trading activity. Trading major pairs allows both traders and investors to efficiently trade in currencies with minimum slippage in prices.2. Large-cap stocks
Large-cap stocks are shares of those companies that have large market capitalisation, stable earnings, proven track records, and pay dividends regularly. Large-cap stocks generally are less risky and volatile than stocks of smaller companies. They are suitable for those investors who seek long-term growth and stability. Moreover, large-cap stocks usually are included in indices of the major stock markets, which makes them prime holdings for several institutional investors. The inclusion of large-cap stocks in any portfolio provides stability, diversification, and potentially consistent returns, particularly during an economic downturn.3. Commodities
Commodities are basically agricultural products or raw materials that are purchasable and saleable, like silver, gold, agricultural products, industrial metals, and crude oil. Commodities have been known to be the global economy’s building blocks and can be traded on any registered commodity exchange worldwide. Additionally, their value lies in their utility, demand, and scarcity across several industries.Trading in commodities leads to diversification and hedges against currency fluctuations and inflation. Commodities markets are known for their price transparency and high liquidity and offer ample opportunities for investors to book profits from demand and supply fluctuation dynamics globally.
What are the most illiquid markets?
Real estate and small-cap stocks are known to be the most illiquid markets. The market for real estate in relatively smaller cities is often characterised by low liquidity owing to wider bid-ask spreads, substantial price impacts arising from single sales, and infrequent transactions. Small-cap stocks that are traded in low volumes by fewer participants in the market tend to be more illiquid and result in more price volatility and wider bid-ask spreads.1. Exotic forex pairs
Exotic forex pairs are currency pairs comprising one universally accepted major currency and another currency of an emerging or developing market. For instance, the US dollar may be paired with the ZAR or South African Rand, or the Euro being paired with the Turkish Lira.An exotic pair’s characteristics are high volatility, low trading volumes, lesser liquidity, and broader bid-ask spreads. This makes them riskier for retail investors who refrain from trading in them. Hence, trading in an exotic forex pair needs prudent risk assessment and management owing to unpredictable and rapid fluctuations in price.
2. Small-cap stocks
Small-cap stocks are shares of those companies that are characterised by relatively smaller market capitalisation. Even such stocks show high growth potential and are also riskier when compared with large-cap stocks. Although they are likely to offer opportunities for substantial capital appreciation, they are less liquid and more volatile owing to fewer numbers of institutional investors and low trading volumes.Thus, small-cap stock investments need thorough research on risk assessment. Even though they may yield substantial returns, the investor needs to be prepared for rapid price fluctuations and liquidity-related challenges.
Conclusion
Market liquidity measures the ease and efficiency with which assets, such as stocks, can be bought or sold on markets at stable prices. It assesses how swiftly investors can convert their assets into cash without causing significant price fluctuations. While some companies' stocks may trade easily, their liquidity levels can still vary. Illiquidity occurs when there's a lack of market participants, hindering smooth transactions. Therefore, liquidity is crucial for ensuring a healthy and functioning market, providing investors with confidence and the ability to execute trades promptly and at fair prices.If you are an investor and want to start your investment journey, you can visit the Bajaj Finserv Mutual Fund Platform to learn more about mutual fund schemes and SIPs. You can use the mutual fund calculator to calculate your financial goals. Calculate the returns on your investments in mutual funds to ensure your investment strategy aligns with your financial objectives.
