Marketability and liquidity Apr07 part 1

[Louisa]

Some questions about Q2 in this paper - can anyone here help?

The examiners comment that there is a difference between marketability and liquidity, but I'm failing to understand their definitions of either clearly.

There seem to be several related concepts.
"Marketability is the ability to trade an asset at a given price in given volumes."
is the first definition. That this relates to "ease of trading", fine. Finally "How long it takes to deal and at what cost" suggests that being able to trade at a given time, and for low transaction costs, are also part of marketability.

Compare to Wikipedia's definition of liquidity:
"A liquid asset has some or more of the following features. It can be sold (1) rapidly, (2) with minimum loss of value, (3) anytime within market hours."
- sounds rather similar to me.

The examiners' definition of liquidity doesn't seem to correspond to my intuition of the thing. They mention two concepts. "It measures how soon the asset will turn into cash *without being marketed*", and "A measure of how the capital values move." The implication later in the question is that assets with volatile capital values are illiquid. It's not clear to me whether either or both of these are a definition of liquidity, or consequences of it.
"Close to cash" is helpful as an intuition but not as a definition as far as I can see.

Okay, so intuitively it's clear a non-transferrable asset is not marketable but could be liquid.
What about
a long term bond which is highly marketable - I'd think this'd be liquid, as it's easy to get the cash if you need it? but it won't turn into cash without being marketed.
foreign currency - presumably both liquid and marketable in normal circs, but the value may be volatile in local currency?

Cheers,
Louisa

 

[Erik]

I don't really get the difference either. My flashcard definition says liquidity risk is the risk that an you cannot trade a certain asset without adversely affecting the price, which I think is more or less the same as the marketability definition in the examiner's report.

But, on the other hand, the examiner's report does make some sense, if you take equity for example: Highly marketable, but not liquid. It is marketable since it can be traded quickly and not too expensively. It is not liquid since if you want to convert it to cash quickly, you might have to take a loss if the market is in a down cycle.

I am not going to worry about this too much. It seems like in past exam questions the two are used interchangably.

 

[Anna Bishop]

Hi Louisa

I think the Wikipedia definition of liquidity that you quote is a good one.

"A liquid asset has some or more of the following features. It can be sold (1) rapidly, (2) with minimum loss of value, (3) anytime within market hours."

(1) and (3) relate to converting into cash quickly

(2) is the bit about not being volatile

I think this does tie up to the examiners interpretation.

The chapter on bonds is also useful. Liquidity preference theory. This says that short-dated bonds are more liquid than long-dated bonds. However, short-dated and long-dated bonds are both quick to sell, and there is a big market in both. So what is it that makes long-dated bonds less liquid? It's because long-dated bonds have a more volatile price than short-dated bonds. So long-dated are less liquid.

To see the price volatility bit, think about how to value a bond.

Simple bonds, zero-coupon

Price = 100/(1+i)^n

Say interest rates change. The price of a long-dated bond will change by more than a short-dated bond. (Try some numbers.)

Hope this helps

 

[didster]

I also had trouble when I did this in the exam.

Seems the definations are

Liquidity - how easily it can be converted to cash (at fair value)
Marketability - how easily it can be sold.

Very Very Very subtle difference there I think.
There's not much in the CA1 notes but there is about 2 pages in the ST4 2007 notes on the difference if you have access to it. (I cant remember the chapter /page off hand)

My opinion is that they are often used interchangebly and most likely a similar question will not come up again in the near future, so shouldnt be too much of a concern.

 

[Louisa]

Thanks all -

Anna, I see your point about long term implying volatility. I guess volatility implies lack of liquidity because of Erik's point about having to sell quickly at an unfavourable price?

Assume volatility of capital values is not equivalent to liquidity in itself, as they appear as separate items in lists iirc. (doesn't liquidity get tagged onto SYSTEM T somewhere?)

I took wikipedia's "minimal loss of value" to mean that the price is not affected by selling the desired volume, not that the price is stable over time.

Thanks didster - I'll see if I can find someone with the relevant ST4 pages - not a pensions fan myself. As you say, unlikely to come up again anyways.

Cheers,
L

 

[samuel_von_gudmange]

This is a useful discussion - thanks!

Just to check that I understand:

Something can be marketable without being liquid if it cannot be sold quickly for a fairly certain value. Erik gave the example of shares.

But can something be liquid without being marketable? The definition of liquidity from wikipedia is something that can be sold (1) rapidly, (2) with minimum loss of value, (3) anytime within market hours.

Don't (1) and (3) pretty much correspond to marketability?

The only things that are missing from this as a definition of marketability (as I understand it) are (4) low transaction costs and (5) being able to sell in large amounts without affecting the price. Would we really say that something would be liquid if these two things don't hold though?

Sorry if I've missed something really obvious, yet again!

 

[Anna Bishop]

An example of an asset that is liquid but not marketable is a term deposit. Very close to cash, not volatile, but you can't actually sell it so it is not marketable.

Note that the wikipedia definition says that some of the following features hold. Not all have to hold.

"A liquid asset has some or more of the following features. It can be sold (1) rapidly, (2) with minimum loss of value, (3) anytime within market hours."

AB

 

[Gareth]

The chapter on bonds is also useful. Liquidity preference theory. This says that short-dated bonds are more liquid than long-dated bonds. However, short-dated and long-dated bonds are both quick to sell, and there is a big market in both. So what is it that makes long-dated bonds less liquid? It's because long-dated bonds have a more volatile price than short-dated bonds. So long-dated are less liquid.

I'm not sure I agree with this. Liquidity implies depth of market and the ability to convert the asset into cash quickly.

The volatility of market value of the asset w.r.t. interest rates is not a factor here. Long dated bonds can have a very deep market and you can trade instantaneously. Whether of not the asset value will change with interest rates has no effect on the ability to convert it into cash.

Liquidity preference theory is not saying long dated bonds are less liquid, it is saying investors will demand a premium for investing in more volatile assets (since their market value moves by a larger degree when interest rates change).

 

[NeedToQualify]

I would disagree on this.

My understanding of liquidity is that liquidity= marketability + stable\fair capital value

I think the examiners answer is really bad and possibly wrong.

Practisioners and the exam material usually use marketability and liquidity interchangeably.

Marketability is whether you can trade an asset or not at the required time at the required quantity. It doesn't require no loss of value on trading.

Liquidity requires marketability and no loss of value on trading. i.e. when you try to sell\buy an asset its price must remain stable\fair. For example when trading an illiquid asset in large quantities the market can respond by increasing its price while you are buying it (i.e. move against you). You need marketability otherwise you wouldn't be able to trade it!

So, long dated gilts are less liquid than short dated ones because they have a higher volatility of capital values. This is why a trader who expects a decrease in interest rates moves to longer dated bonds, because the impact on price would be higher. (higher duration means higher volatility)

Market liquidity is a different but related concept. There is another concept of liquidity which refers to the ability to meet your liabilities as they become due.

Also I would disagree that a term deposit is necessarily liquid. It follows the same rules. It is only liquid if it is very short term (thus compensating for the lack of marketability).

 

[Gareth]

Also worth noting in the core reading unit 7, page 21 it says:

"many less developed markets are not very liquid".

This should say marketable according to the A2007 paper... (or are they saying cash like investments don't exist in emerging markets ;-) )

Unit 8, page 20 defines liquidity risk as "market not deep enough..." which is conflicts again with A2007: "Marketability is the ability to trade an asset at a given price in given volumes" - given volumes implies depth...

Basically I think once again the Institute are misunderstanding investment...