Appraise the defining features of markets that are illiquid.
The idea
A market is illiquid when an investor cannot turn an asset into cash quickly, in size and at a price close to fair value. Typical signs are infrequent trading, wide bid-ask spreads and other high transaction costs, and costly search for a counterparty because trades are bilateral and over the counter. Assets are unique rather than standardised, and a large order has price impact. Liquidity has three dimensions. Tightness is the spread, depth is the size that trades without moving the price, and resiliency is how fast the price recovers after a trade. Because trades are rare, observed prices are scarce and values come from appraisals or models. Liquidity also varies over time and tends to vanish in many markets at once in a crisis. The exam point: a narrow quoted spread does not prove a market is liquid if depth is thin.
A practice question
Which description best fits an illiquid market?
- Trades are infrequent, transaction costs are high and prices are rarely observed. - correct
- Dealers post continuous two-sided quotes and large orders are absorbed with little price change.Why not: Describes depth and resiliency, which are features of a liquid market, not an illiquid one.
- Identical assets trade on a central exchange with real-time prices and heavy volume.Why not: Describes standardisation and centralised trading, which are features of a liquid market.
- Bid-ask spreads are narrow and investors can sell any size within minutes.Why not: Narrow spreads and immediacy for any size are the definition of liquidity, so this reverses the concept.
Illiquidity shows up as rare trades, costly execution and a scarcity of observable prices. The other descriptions each depict a liquid market with standardised assets, depth and tight spreads.
A harder one
A trader says a corporate bond must be liquid because its quoted bid-ask spread is only 2 basis points. Why might the bond still be illiquid?
- A narrow spread shows that the bond trades rarely, and rare trading is the definition of illiquidity.Why not: Reverses the relationship: a narrow spread does not imply infrequent trading and says nothing of the kind.
- The bid-ask spread measures only credit risk, so it carries no information about liquidity.Why not: Confuses the bid-ask spread with the credit spread; the bid-ask spread is a direct transaction cost.
- The quote may apply only to small sizes, so a large order would face thin depth and a substantial price impact. - correct
- Spreads are earned by dealers for holding the bond over long periods, not for executing trades.Why not: Misreads the spread as a holding-period return; it is the round-trip cost of trading, quoted for a particular size.
Tightness, depth and resiliency are separate dimensions. A tight quote for a small size says little about depth, so large trades can still move the price a long way.
The hardest tier
A fund must sell a position of USD 60 million in a bond that trades about USD 5 million a day. To limit price impact, the fund will trade no more than 20 percent of daily volume. The number of trading days needed is closest to:
- 12 daysWhy not: Ignores the 20 percent participation limit and divides the position by the full daily volume.
- 2.4 daysWhy not: Multiplies the position by the participation rate before dividing by volume, when the rate should apply to the volume.
- 60 days - correct
- 300 daysWhy not: Multiplies the position by the daily volume instead of dividing, which makes no sense dimensionally.
Daily tradable amount = 20% x USD 5 million = USD 1 million, so days = 60 / 1 = 60. A large position relative to market depth takes a long time to exit without price impact.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Illiquid Assets
- Examine the link between imperfections in markets and a lack of liquidity.
- Weigh up how biases affect the returns reported for illiquid assets.
- Account for how returns are unsmoothed and what unsmoothing does.
- Set the premiums paid for bearing illiquidity risk against each other, both across asset categories and within a single category.
- Appraise the consequences of putting illiquid assets into a portfolio, for rebalancing and trading as well as for deciding how large a proportion of them is optimal.