Liquidity of the market

The liquidity of a financial market appears among essential qualities that must guarantee the purses of values. It is a concept which remains still difficult to define. A consensus seems however to be established to affirm that the liquidity of a title expresses the facility for an investor to quickly find a counterpart for an order of broad size whatever the direction of the transaction without causing important variation of the course. The more liquid one market is, the more it is easy, fast and inexpensive to carry out transactions there.

Liquidity and choice of credits

The liquidity of the credits became, during these last years, a dominating element of the strategies of investment. A great part of this interest for the liquidity comes from the difficulties of absorption by the market met by the investors who wish to deprive or acquire a significant quantity of actions of weak market cap. Such negotiations induce sometimes folds or rises of excessive courses.

Thus, managers of funds, especially if they manage important lines whose negotiation can weigh on the courses, privilege the most liquid actions. That enables them to reduce their costs of transactions, to instigate their wallet (engagements and disengagements can be carried out quickly) and to avoid, of course, that the performance of the funds is disturbed by the absence of a sufficient Contrepartie, would be this only temporary, on the market. In the same way, the treasurers of the companies which wish to acquire transferable securities within the framework of short-term placements will privilege the easily negotiable and liquid credits.

The models of valuation of assets take today into account premiums of liquidity. Hamon and Jacquillat propose an extension of MEDAF by adding a factor of liquidity:

$E\; \backslash \; left\; (r\_j\; \backslash \; right)\; =\; r\_f\; +\; b\_\; \{J\}\; *\; -\; r\_f\; +\; L\_\; \{J\}\; *Liq\_\; \{J\}$

The formula is a function:

• of the measurement of the systematic Risk of the credit, i.e. diversifiable risk not (the investor will diversify its wallet directly on the market), noted $b\_\; \{J\},$ (coefficient beta of the credit);
• of the Profitability hoped on the market, noted $E\; (r\_m)$;
• of the Interest rate without risk (generally of the Government loans), noted $r\_f,$.
• of the liquidity, noted $Liq$, measured by the price range, it floating or the turnover .

The models with several factors can also retain a premium of liquidity:

$E\; \backslash \; left\; (r\_j\; \backslash \; right)\; =\; r\_f\; +\; b\_\; \{j1\}\; RP\_1\; +\; b\_\; \{j2\}\; RP\_2\; +\; \backslash \; cdots\; +\; b\_\; \{jn\}\; RP\_n$

$r\_j\; =\; E\; \backslash \; left\; (r\_j\; \backslash \; right)\; +\; b\_\; \{j1\}\; F\_1\; +\; b\_\; \{j2\}\; F\_2\; +\; \backslash \; cdots\; +\; b\_\; \{jn\}\; F\_n\; +\; \backslash \; epsilon\_j$

where

* $E\; (r\_j)$ is the hope of profitability,

* $RP\_k$ is the allowance for risk of the factor,

* $r\_f$ is the rate without risk,

* $F\_k$ is the risk factor (inflation, liquidity…),

* $b\_\; \{jk\}$ is the sensitivity to the risk factor $k$,

* and $\backslash \; epsilon\_j$ is a risk of null average (specific risk).

As example, one can quote the model with three factors of Fama and French which retains a premium of liquidity. This one is equivalent to the difference in profitability between the actions the large ones and small capitalizations.

$r\_j-r\_f=b\; \{1\}\; (r\_\; \{m\}\; -\; r\_\; \{F\})\; +b\; \{2\}\; \backslash \; cdot\; SMB+b\; \{3\}\; \backslash \; cdot\; HML+\; \backslash \; alpha$

where

* $SMB$ corresponds to the factor cuts (equal to the difference in profitability between great and small capitalizations),

* $HML$ indicates the factor Book to Market (equal to the difference in profitability between values of output and growth).

Liquidity and organization of market

The liquidity of a market depends on its organization (purse or private) but also on the credit considered. For example, the market of the Euro-dollar (by private contract) is extremely liquid, just like the purse of Wall Street. Contrary the market to the real estate is very little liquid. There does not exist optimal structure of market. In Paris, one privileges a quotation uninterrupted for the important market caps and a quotation in fixing for small capitalizations.

The notion of liquidity is often attached to that of Depth of the market.

Risk liquidity

The risk of liquidity corresponds to the loss coming from the costs of liquidation of a position. Typically, the illiquidity of a market appears in the form of important costs of transaction, a low number of transactions during the meeting or a high price range. It is manifest that the majority of the markets know sometimes problems of liquidity. Indeed, of many markets do not have an acceptable level of liquidity during all the meeting; there only exists very little of markets, which can be praised to offer an adequate level of liquidity to the financial speakers. However, even the liquidity of these great stock exchange places cannot be guaranteed. These markets are very liquid the majority of time, but occasionally at the meetings of crisis, their liquidity “is drained”. It is possible to distinguish two types of risk of liquidity. The first is the “normal” risk of liquidity which increases with the liking of the exchanges on markets considered as not very liquid. The second type of risk of liquidity is more insidious. It is about the risk of liquidity which increases at the time of the stock exchange crises where the market loses its current level of liquidity.

The normal risk of liquidity

The risk of liquidity corresponds to the potential loss which one undergoes compared to the price that one should have obtained. One must onc focus oneself on the market price: the risk of loss occurs because of unfavourable movements of the contract price. However it is advisable to what is called pay attention at “contract price” in particular when one is located on a liquid market: the posted price does not mean “real price”. This one can result very well from a former lack of liquidity.

The risk of crisis of liquidity

A market can be very liquid most of the time and become illiquide at the time of a major crisis. In general, the disorders start when a fall of course intervenes, i.e. when one attends an excess of offer of titles vis-a-vis a request which tends to be strongly reduced by distrust with respect to the titles. The price range tends to increase in an important way. That is explained by the effect of panic which reigns on the market, all the investors wish to sell at the same moment and dismantle the notebook of orders of with dimensions purchaser. Besides this explains the installation by the stock exchange authorities of the reservations of quotation. One is in a situation where there does not exist any more strategy of placement: everyone wishes to sell its position.

See too

Internal bonds

• MEDAF
• Coefficient beta

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