Virtually all financial indices are constructed from transactions prices. For very liquid markets such as the New York Stock Exchange, in which assets trade every day, the weighted average price adequately captures daily market dynamics. But for less liquid markets, such as the bond market, the housing market and the art market, the average observed transaction price might not be as informative. In fact, even the construction of an intra-day index of the NYSE poses a challenge due to illiquidity.
A substantial body of research demonstrates that, all else equal, investors prefer stocks that are liquid and that transparency has the potential to improve liquidity (for a summary see, Amihud, Mendelson and Pedersen (2005)). However, the concern for an investor is broader than simply the average level of liquidity because what matters is the liquidity at the time they choose to transact. Investors prefer firms with relatively predictable liquidity because they are able to better anticipate the likely trading costs associated with closing a position at the time they make the initial purchase decision. To the extent a stock’s liquidity is highly variable, it increases the uncertainty attached to a position and limits a potential investor’s flexibility. For example, investors who need to reduce overall exposure may face the alternative of either selling shares at substantially below intrinsic value due to price pressure or switching to liquidating other positions.
The liquidity squeeze during the ongoing sub-prime crisis of 2007-08 has been likened by some observers, including the IMF, to the financial sector turmoil of the Depression era. A nagging problem faced by central banks during the early part of this crisis was the difficulty in getting open-market operations, discount window and securities lending to channel liquidity to the most needy parts of the financial system. Some of the lending facilities such as the discount window were not availed by players, and others when availed merely resulted in hoarding of liquidity by banks and other institutions.
In the UK, for example, banks’ liquidity buffers have experienced an almost permanent upward shift of 30% in August 2007 (relative to their pre August levels) and the result has been a rise in borrowing costs between banks and an almost complete drying up of liquidity exchange in money markets beyond the very short maturities. In response, central banks around the world, most notably the US Fed, have undertaken significant changes to their lender-of-last-resort facilities, in particular, by extending maturities of discount window and open-market operations, extending eligible collateral to include investment-grade debt securities, and making such adjustments for lending to primary dealers as well.
