Liquidity in the Secondary Market: Liquidity is the ability or power of an asset to be converted into cash or near cash at the time needed without loss. A liquid asset is a readily marketable asset with a relatively stable price that is reversible. Perfectly marketable assets are called perfectly liquid assets. Whenever sold they suffer no price decline.
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Most securities have more money less than real assets but are not perfectly liquid assets like cash. That is, securities are more liquid than real assets but less liquid than cash and demand deposits at a bank.
Investors pay a slightly higher price, called a liquidity premium for assets that are more liquid.
Illiquid asset, on the other hand, is the assets that can not be sold quickly unless the seller incurs significant execution costs that include the following components:
In fine, liquidity of an asset is the ability to buy or sell the same quickly without causing any significant change in its price. Liquidity varies inversely with the costs incurred when buying and selling. The liquidity of a security increases as the volume of trading in it increases.
Dealer and broker work together to create a liquid market as their work is easier and their cost of doing business is less in liquid markets.
However, the followings are the qualities that a liquid market must possess:
Depth being the position where buy and sell orders exist both above and below the price at which the security is trading. A market without depth is called a shallow market.
Breadth being a position where buy and sell orders exist in volume. Markets lacking the volume of orders needed to provide liquidity are called thin markets.
Resiliency where new orders pour in immediately in response to price changes caused by temporary order imbalances. A speedy price discovery process is essential for resilient.