What is liquidity in a financial asset and why would you want it? September 12, 2012 at 3:25 pm
Lisa at FT Alphaville, linking to some Citi research, suggests that there are the following measures for bonds. The italics are Lisa’s comments; mine are in roman.
- Absolute number of block trades. These are defined as a trade size of over $5m for high-grade bonds, and $1m for high-yield. Once they have the count over the last 60 days, they logarithmically rank them within their own sector (high-grade or high-yield).
- Consistency of block trading activity. Consider the first factor more closely — if there were, say, 45 block trades in the 60-day window but they were all on one day, that doesn’t exactly shout liquidity! If, on the other hand, the trades were spaced out, that’s probably a better sign. This factor also involves a logarithmic ranking.
- Client trading activity. This is where the Citi strategists start to get creative, and where it also becomes apparent that they are building this liquidity measure for their clients. Here they count up the number of trades that actually involved a client rather than just the Street selling to the Street, i.e. client-to-dealer rather than dealer-to-dealer. Additionally, they adjust this variable by factor 1) above.
This makes sense; interdealer pass the parcel can easily go away, whereas genuine two way client flow is more durable.
- Market balance. This is a measure of the amount of two-way activity seen in the client trades of the previous factor. If there are as many client buys as sells, then it’s more likely that trades can be executed without moving the market. This factor is also weighted by 1) above.
A thousand sellers and one buyer, even if all the trades clear is likely not durable liquidity; if the buyer exits (cf. ABS CDOs buying RMBS mezz tranches) then the market disappears.
- Compensation for non-default-related spread volatility. This (pace Alphaville) is straightforward; if the liquidity premium is highly variable, then the market is patchy, whereas if it is more or less constant, then prices only move when there is a change in fundamentals. This isn’t pure liquidity, but it is correlated with trading activity, so it is a useful measure.
Why would you want it? Well, if you needed to sell. That much is obvious. What is perhaps less obvious is that high quality but illiquid assets are good for some investors, like pension funds, who are often hold to maturity, and who can get paid to take illiquidity risk. Indeed arguably pension funds should not be invested much in liquid assets at all as they are paying for liquidity that they don’t need. What everyone needs to know, though, is whether they are receiving sufficient compensation for the liquidity risk they are taking. These measures at least help in that judgement.
It is commonplace to add to these additional measures:
- Price impact of a trade. Roughly, how much you move the market when you do a big trade.
- Recovery time. This is simply how long it takes prices to recover after a ‘big’ trade hits the market, whatever ‘big’ means.
- Bid/offer spread. Lower spreads tend to mean better liquidity.
- Quote availability. While a quote does not mean that you can trade, no quotes tend to imply that it is harder to trade.