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The value of liquidity

Asia Analytica
Asia Analytica6/11/2021 06:31 AM GMT+08  • 5 min read
The value of liquidity
There is a price to liquidity, or rather, illiquidity.
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Liquidity has value. We know this. It is why people hold cash instead of investing it, even though cash does not yield any returns. It is also why we are willing to keep money in current-savings accounts even though the interest income is very low compared with fixed deposits — we know can withdraw cash more easily in emergency situations. In other words, the value of cash is its immediate monetisation.

Different investment assets have varying degrees of liquidity — in terms of the ease of buying and selling without causing material changes to prices. So, publicly traded stocks where there are many standing buyers-sellers are generally more liquid than shares in private assets, and bonds will be more easily converted into cash than real estate (property).

There is a price to liquidity, or rather, illiquidity. For example, money market investments with very short maturities are highly liquid assets, so much so that they are commonly equated to cash investments. But that also means their yields are generally lower than long-dated bonds, which lock up your money for longer periods of time. You will, though, earn higher yields (income) on the latter — called the liquidity premium — to compensate for the higher risks of default, inflation, interest rate changes and so on during the duration to maturity. Hence, a yield curve under normal circumstances has a positive slope.

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