Overview
When a stock, bond, or other asset cannot be sold or exchanged for cash without a significant loss in value, we say that it is illiquid.
When there aren’t many buyers and sellers in the market for an item, it might be difficult to turn a profit rapidly.
This is because fewer investors and speculators are interested in buying or selling the asset. Lower trading volume, larger bid-ask spreads, and higher price volatility are all symptoms of illiquid assets.
Illiquidity is the opposite of liquidity.
KEY PHRASES
- A securities or other asset is illiquid if it is difficult or impossible to convert it into cash quickly and without a significant loss in value.
- Actively traded securities are likely to be more liquid than illiquid ones because of the greater number of buyers and sellers they attract.
- Investment risk is higher for illiquid assets due to their wider bid-ask spreads and increased volatility.
The Meaning of “Illiquidity”
When it comes to illiquid assets, the gap between the seller’s asking price and the buyer’s offer price widens because there are fewer potential bidders.
This disparity causes bid-ask spreads to be far wider than they would be in a regulated market with normal trading volume.
When an investor needs to sell quickly, illiquid assets can be a bad bet because there aren’t enough buyers in the market.
Although illiquidity in the context of a business does not imply the absence of assets, it does signify that the company lacks the cash flows essential to meet its due debt payments.
Real estate and manufacturing machinery are two examples of capital assets that can be valuable yet difficult to liquidate in times of financial need.
A company’s primary function is not to engage in the trading of illiquid assets. The company’s assets are everything it owns besides its manufactured goods.
To avoid bankruptcy, a corporation may have to swiftly sell off its assets, a process known as a “fire sale,” at prices substantially below what they would fetch in a more orderly situation.
In addition, if a corporation can’t get the cash it needs to pay its debts, it may become illiquid.
Examples of Illiquid And Liquid Assets
Houses and other real estate, cars, antiques, private company interests, and some forms of financial instruments are all instances of intrinsically illiquid assets. Some works of art and collectibles can also be difficult to sell quickly.
Similarly, OTC stocks are typically less liquid than their exchange-traded counterparts.
While these items may be valuable in and of themselves, there may not be as many buyers in the market for them as there would be for more liquid investments.
Conversely, stocks, ETFs, mutual funds, bonds, and listed commodities, which are all traded on major exchanges, are extremely liquid and can be sold virtually instantly during regular market hours at fair market pricing.
In addition, gold and silver are two of the most liquid of the precious metals. Another cause of market illiquidity is trading outside of regular business hours, when fewer traders are present.
The degree to which an item is easily traded might shift over time in response to fluctuations in the market.
In the case of collectibles, when an item’s appeal on the consumer market can rise and fall rapidly, this price volatility is more pronounced.
Low liquidity and Risks
As the ratio of buyers to sellers is thrown off balance during market upheaval, illiquid equities have higher risks than liquid ones, known as liquidity risk.
In these conditions, investors holding illiquid securities may be unable to sell them at all or may incur significant losses if they try to sell.
In addition, the price of illiquid securities may include a “liquidity premium” to reflect the fact that they may be costly to sell when needed.
A liquidity crisis occurs when sellers of even marketable securities have trouble finding interested purchasers at reasonable prices due to a freeze-up in markets and credit facilities brought on by a financial panic.
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Application To The Real World
Companies and people alike may experience illiquidity if they are unable to generate sufficient cash flow to meet their financial obligations.
For instance, Jet Airways has reportedly delayed repayment of overseas debt for the fourth time “in recent months” due to a corporate illiquidity situation that has made it difficult for the corporation to get liquid funds.
The airline grounded more than 80 planes and devised a resolution plan that included the departure of its chair, Naresh Goyal, and the board’s approval of a takeover by the carrier’s lenders.
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