Behavioral Finance

CHAPTER 19

Liquidity

Asset liquidity is concerned with how quickly a collection of assets can be turned into cash and at what cost. Cash is the most liquid asset. Close behind are recently auctioned U.S. Treasury bills. It is relatively easy to buy or sell large numbers of U.S. Treasury bills at a price not much different, if different at all, from the most recent transaction price. That suggests a definition of illiquidity as the difference between the most recent transaction price and the price at which a purchase or sale could take place quickly in which the size of the purchase can vary from small to large.

The problem with this kind of definition is that the most recent transaction price could have occurred a long time ago. Think of selling or purchasing a house. The house may have been last purchased or sold many years before, so the most recent transaction price is likely to be very stale and not very relevant to the current transaction.

As this example indicates, liquidity is one of those things that people talk about, but it is a concept that is difficult to pin down in practice. Large-capitalization stocks are thought to be more liquid than small-capitalization stocks. Recently auctioned U.S. Treasury bills are seen as more liquid than treasury bills that were auctioned at an earlier date. U.S. Treasury securities are deemed to be more liquid than U.S. agency issues. Objects of art are viewed as less liquid than fruits and vegetables.

But what does liquidity mean? How ...