Aug 31

Liquidity risk: Factors that impact liquidity

by David Harper, CFA, FRM, CIPM

LO 20.3: Discuss factors that impact an asset's liquidation cost.
LO 20.4: Discuss problems with using the bid-ask spread as a measure of liquidity.

Previously we defined liquidity risk. Now consider the factors that impact asset liquidity, as provided by Culp.

	Factor
	Time horizon	This refers to seller's patience level. Or, if funding liquidity risk, the CFO's urgency to fund operations. Less time implies higher liquidation costs.

	Asset type	Simple assets tend to be liquid (one year Treasury bill), complex assets (e.g., CDO-squared) tend to be illiquid.

	Asset fungibility (interchangeability)	If a position can be offset with other instruments/ counterparties (e.g., futures), fungibility is high. If position must be negotiated (e.g., swaps), fungibility is low.

	Market microstructure	This refers to (1) whether market is around-the clock *continuous* like foreign exchange markets or auction-type *call markets* like U.S. Treasuries; and (2) whether market is centralized (NYSE specialists) or decentralized (e.g., CBOT)

	Bid-ask spread	See next

The bid-ask (or bid-offer) spread) and the bid-ask spread is a common measure of liquidity. In the quote below for IBM, the bid-ask spread is $1.50. Or, in percentage terms 1.89% ($1.50 spread divided by ask), possibly 1.9% ($1.50 spread divided by midpoint between ask & bid).

Problems with the bid-ask as a proxy for liquidity include:

The most important is the implicit assumption that the spread is independent of the trade. The spread is where the marginal buyer meets the marginal seller, so trade does impact the spread. The larger the position, the more likely the trade will alter the spread.
Not unrelated, the spread may be valid for small orders but invalid for large orders
There may be more than one bid-ask spread. Transactions may occur within the spread, these are measured by effective spread rather than the quoted spread
It includes additional costs above pure "liquidity;" e.g., dealers need to get paid. As Culp says, "the supply of immediacy--the provision of order execution on demand--is costly."