Liquidity Is Important for Financial Planning

Liquidity Is Important for Financial Planning

In stock trading, liquidity describes the characteristic of an economic entity that allows an investor to easily buy or sell a particular asset with little or no impact on the financial value of the firm. In other words, liquidity relates to the ability of an entity to perform the expected trading functions. Liquidity is also related to risk and the degree to which investors are willing to assume risk in exchange for potential gains. Liquidity also has a key role in price determination.

In the business, equity, equities or fixed assets are the most common assets that are traded on exchanges. In asset pricing, liquidity refers to the characteristic of an economic entity that permits an investor to easily buy or sell equities or fixed assets without causing a dramatic change in the value of the underlying asset. Liquidity includes the trade-offs between the potential sale price of equities or fixed asset, and the time it takes for an investor to recoup his investment in an efficient manner. This is called the discount rate of the security.

Liquidity is important to both buyers and sellers. When an investor wants to sell a particular asset, he needs to have confidence that another buyer will be able to acquire the same for less than the current selling price Liquidity. The risk involved in holding an asset incurs expenses if there is a change in the number of buyers who are interested in purchasing it. These include costs associated with the research of possible buyers as well as administration costs. Holders will have to bear these costs in order to sell their assets. Conversely, when an investor wants to purchase an asset, he needs assurance that a buyer is prepared to take possession of, and pay for, the same.

One example of illiquid assets is fixed income securities. These include bonds, notes, and loans. While many sectors suffer from a lack of liquidity, equities stand out because they are the most liquid financial assets. Bonds, notes, and loans are not easily traded as they are held by only a few individuals.

A bond, note, or loan in pooriquidity can suffer price changes due to changes in economic conditions. When an investor sells an equity bond, he must first cash in on the original purchase and wait for the market price to become favourable. If the selling price is greater than the price he paid for it, then he has lost some of his initial investment. If this occurs more than once, then he is in a poor liquidity position.

Fixed income securities also experience changes in liquidity when interest rates are changed. This is because the principal value of the bond, note, or loan is not fixed but a proportion of the initial market price is changed into a value that is directly remunerated to the holder. When this occurs, investors will sell off these assets if their principal value has decreased. When this occurs, a change in liquidity means that there has been a trade-off taking place between the value of the assets available to investors and the value of the principal remaining on the balance sheet.

Market makers make their profit by selling the bond, note, or loan to the investors. Since the bond, note, or loan is bought at the current market price, the market makers do not have to wait for the market price to become favourable. Rather, they sell the assets immediately when they become valued below the investment. The market makers buy the assets from investors at less than the present market price and sell them to other investors when the market price becomes favourable. The difference in the purchase price and the sale price is their profit. In order to become a market maker, an investor must either buy large amounts of an asset that has low trading costs or invest in a portfolio of low risk investments.

Liquidity is an important part of any well-managed long-term financial planning strategy. There are various methods for determining the level of liquidity that is required for any particular financial instrument. However, it is important to remember that a sudden change in liquidity that occurs for an unexpected reason can have a significant impact on your portfolio. Therefore, it is especially important to closely monitor the level of liquidity for the investments that you have in order to ensure that your portfolio remains robust during times of financial stress.


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