Terms Beginning With 'l'

Liquidity

  • January 07, 2020
  • Team Kalkine

Financial pundits have often stated that the most important thing in business is liquidity. But what is liquidity? Let us deep dive-

What Is Liquidity?

As the term suggests, liquidity is the quality of being liquid or flowing free like water. In the business sense, liquidity refers to the amount of money that is easily accessible for spending and investment. As deciphered, the concept related to quick access to cash.

Some experts even regard liquidity to be the amount of cash and cash equivalents. Another way to look at the concept is this- both individuals and businesses hold assets or security. Liquidity refers to the ease with which these may be bought or sold in the market for conversion into cash. It involves the trade-off between the price at which a particular asset can be bought, and how quickly it can be sold.

Getting the basics- In a liquid market, the trade-off is mild, which means that assets can be sold quickly without having to accept a significantly lower price. On the contrary, in a comparatively illiquid market, an asset is required to be discounted to sell quickly.

Why Is Liquidity Important?

The answer to the above is simple- Liquidity may be the most effective silver lining when one encounters the need for urgent cash, which can occur anytime.

Liquidity is the ability to get one’s money whenever one needs it. It can be looked upon as an emergency savings account or cash lying with someone that can be easily accessed in case of any unforeseen happening or any financial setback. Besides, liquidity plays a vital role as it allows individuals and businesses to seize opportunities. This is because if one has cash and easy access to fund, it is easier to seize any opportunity that comes along.

Financial experts often stress upon the importance of liquidity when one is planning investments. It is crucial to factor liquidity in financial plans to ensure that one has secured its long-term as well as short-term needs. This further should ensure that one does not utilize/ incur a loss to discount their long-term investments when in need.

Discussing the importance of liquidity from an investment perspective-

  • It plays a critical role in balancing one’s portfolio with trade-offs between risk and return.
  • It may help accelerate transactions, as having liquid funds reduces the time-lapse from when the asset is put for sale and by the time one finds a buyer.
  • Liquid funds are known to retain their value when they exchange hands, unlike many illiquid funds.

ALSO READ: What Is Market Liquidity?

Features Of A Liquid Asset

A liquid asset may have some or all of the following features-

What Are The Measures Of Liquidity?

There are two main measures of liquidity-

  • Market Liquidity- Indicates market situation where assets may be purchased or sold off quickly. This type of liquidity is particularly evident in the case of real estate, the stock market or financial market. Markets for real estate are typically far less liquid than stock markets. The shares traded on stock exchanges are usually found to be liquid due to a large number of buyer and seller available, which leads to easy conversion to cash.
  • Accounting Liquidity- The comfort with which a business or an individual can meet financial obligations through liquid assets is accounting liquidity. It requires a comparison of the liquid assets held by the business or an individual to that of current liabilities in a financial year. The current ratio and cash ratio measure this.

 

What Are The Different Liquidity Ratios?

Businesses and individuals use liquidity ratios to evaluate their liquidity. These ratios help them to measure their financial health. The three most important ratios include the current ratio, quick ratio, and cash ratio.

Let us look at a few interesting facts about the above ratios-

  • The current ratio is believed to be the simplest and less stringent.
  • Quick Ratio is also referred to as the acid-test ratio.
  • The cash ratio is believed to be the most exacting of the liquidity ratios. More than the other two ratios, it assesses the business’ or individual’s ability to stay solvent in the case of an emergency.

 

Liquidity Management

At any point in time, and especially in turbulent times, a Company may be asked to demonstrate its ability to remain viable and liquid. This is where liquidity management comes into the picture.

Liquidity management describes a company’s ability to meet financial obligations via cash flow, funding activities, and capital management. It is impacted by revenue and cost generating activities, capital and dividend plans, and tax strategies- making it a challenging concept. Liquidity management is strongly associated to broader market, credit and general business risks.

So how is liquidity managed?

For starters, monitoring the liquidity ratio is key to keep a regular grasp of the company’s liquidity risk. To do so, most liquid assets are compared with short term liabilities or near-term debt obligations.

Other techniques comprise-

  • Receivables management– the stringent methodology to make sure that clients and customers maintain payments in a timely and orderly fashion.
  • Netting portfolio management techniques- which allows the company to consolidate debt obligations. Herein, the company nets third-party invoices. It is usually applied when the company has several outstanding invoices from the same vendor and agree on terms by which the total outstanding amount will be paid on a certain date. By practising this approach, a single payment suffices rather than a number of instances to unsettle cash reserves.

 

Understanding Liquidity Glut & Liquidity Trap

While walking through the concept of liquidity, understanding liquidity glut & liquidity trap is essential.

Liquidity Glut—when savings exceeds the desired investment

As understood, high liquidity means a lot of capital. But what happens when there is too much capital and too few investments? A liquidity glut. This is a situation wherein savings exceeds the desired investment. Often a liquidity glut may lead to inflation. Cheap money pursues lesser profitable investments, and prices of those assets increases.

Liquidity Trap- monetary policy becomes ineffective

This occurs when the Government’s monetary policy does not create more capital; for example, post a recession. In this situation, interest rates are extremely low, whereas savings are high, making monetary policy ineffective. Consumers ideally prefer to save rather than invest in higher-yielding bonds or other investments. Raising interest rates is one of the most effective ways to get out of a liquidity trap, the other being increasing government spending, which may in turn aid unemployment too.

What are ETFs? ETFs are similar to funds where pooled money of investors is managed by a fund manager, who runs the ETF. These funds invest in equity, debt, commodity or any other asset class, depending on its offering. Good read: Mastering the Basics of Investing in ETFs Price of the ETF is based on a value of net assets in the fund and is subject to change each trading day consistent with underlying changes in the value of net assets. Since ETFs are traded in markets just like shares, the quoted price of an ETF either reflects a discount to its NAV or a premium to its NAV. Investors have flocked to ETFs because of low-cost proposition and opportunity to take exposure in a specific pool of assets, which are professionally managed by an investment team with the investment manager. Some ETFs are also used as a proxy to define sentiment in an underlying sector, commodity or index since ETFs are actively traded in market hours, incorporating the latest information in prices. Fund management businesses have continued launching new and innovative ETFs, which have seen great demand over the past.    Read: Gold ETFs register massive capital influx; while PDI, GPP, ERM, AME, RED Under Investors’ Lens Large and popular ETFs have also defied liquidity problems because of large scale investor participation. But it remains a problem with lesser-known ETFs with small market participation. ETFs also pay distributions to the holders that are either derived through interest income, dividend income or capital gain. Active and Passive ETFs With ETFs markets growing strongly as ever, there remains a divide between active fund managers and passive fund managers. Passive investment strategies have grown immensely popular among market participants over time. This strategy is cost effective. Many seasoned investors such as Warren Buffett, John C Bogle- founder of the Vanguard Group have endorsed passive ETFs. Active ETFs do not track a benchmark, and performance is not tracked to any given index. These funds are based on countries, sectors, market capitalisation, asset classes, etc., and active investment management allows a manager to beat the returns delivered by broader markets or indices. If you look at the great investors like Warren Buffet, Philip Fisher or Peter Lynch, they have set themselves as a preamble for active investors, and their record of delivering sustainable returns over the long term continues to attract investors to active alleys of markets. Since Passive ETFs are designed to match returns of respective benchmarks, there is no scope of delivering outperformance no guarantee that fund will not underperform the benchmark. However, the expenses charged to investors are relatively lower compared to Active ETFs. Passive ETFs are cheaper than Active ETFs because the use of resources is limited in the former. Since they are designed to match the benchmark and its underlying securities, trading in Passive ETFs is mostly automated running on algorithms, and stock picking is not required, thereby no research. Read: ETFs: Investors Up the Ante and ETFs Run the Show for Long-Term Returns ETFs based on asset classes and style Sector ETFs: These are the most common type of ETFs in market. Sector ETFs track specific sectors like Information Technology, Consumer Staples, Consumer Discretionary, Metal & Mining. These are similar to index funds but are actively traded in stock exchanges. Equity ETFs: Equity ETFs may include equity-focused Sector ETFs. As the name suggests equity, these funds invest in stocks independently or are benchmarked to a specific index. Perhaps, Equity ETFs are the most common ETFs. Fixed Income ETFs: These funds invest in fixed income instruments and pay distributions out of the interest earned on bonds. Further Fixed Income ETFs can be separated as investment-grade ETFs, high-yield ETFs, Government bond ETFs. Commodity ETFs: Commodity ETFs invest in physical commodities like precious metal, agricultural goods, natural resource. These funds include products like Gold ETFs, Oil ETFs, Grain ETFs, Silver ETFs. Good read: Investing in Commodity ETFs Short ETFs: Also known as inverse ETFs, these funds are designed to benefit when the benchmark is falling. Short ETFs hold short positions in the benchmark index futures or constituents of the index to benefit from fall in value or prices. To know more about short selling read: Minting Money While the Asset Price Tanks; Enter the World of Short Selling Leveraged ETFs: Leveraged ETFs use derivatives to amplify the returns and risks of a fund. These are also called geared ETFs. Leveraged ETFs may also hold equity or bonds along with the derivatives to amplify the net asset value movement of funds. Do read: All You Need to Know About Exchange Traded Funds Why investors prefer ETFs? Passive investment vehicles continue to appear compelling to a large investor base, and there are numerous reasons driving the demand for passive investment vehicles. Low-cost and no minimum investment: ETFs have lower expenses compared to traditional mutual funds, and most of the funds have no minimum investment criteria. As a result, the market for ETFs has grown strong, due to its reach to investors with limited capital. Must read: Mutual Funds vs. ETFs: Which Are Better? Exposure to specific asset classes: Investors with large portfolio also use ETFs to enter to into specific asset classes like Gold ETF or Commodity ETF, but not limited to sector ETFs, theme-based active ETFs like technology, mobility, e-commerce etc. Portfolio diversification: ETFs provide investors with an opportunity to diversify a portfolio of concentrated stocks by including exposure to specific sectors, indices, and commodities. More importantly, the diversification is available at a low-cost investment, which further drives the need for ETFs in a portfolio. Accessibility: It is perhaps the most compelling value ETFs provide to investors. Since ETFs are available on stock exchanges like shares, investor participation remains strong, and some popular ETFs boast high liquidity levels. Read: Confused on How to Invest in ETFs? We Have Some Tips! Further read: 6 Reasons to look at ETFs    

What is Keynesian economics? Keynesian economics is the economic theory that states demand is the driver of economic growth. This economic theory also states that fiscal aid helps recover an economy from a recession. Certain Keynesian economic principles stand in stark contrast to the Classical theory of economics. The theory was given by John Maynard Keynes in the 1930s and published in Keynes’ “General Theory of Employment, Interest and Money” in 1936. The Keynesian theory stated that government spending was an essential factor in increasing demand and maintaining full employment. What are the theories under Keynesian economics? Aggregate demand is affected by a host of factors: Aggregate demand is affected by various factors public and private factors. Monetary and fiscal policy both affect the level of aggregate demand in the economy. Any decision taken by the monetary authority or the government greatly affects the economy’s level of demand. Say’s Law proposes that supply generates its own demand. However, Keynesian economics suggests that demand is the driver of supply and overall growth in the economy. Sticky Wages: According to the theory of sticky wages, employers would prefer laying off workers over decreasing the existing workers’ wages. This happens because even in the absence of labour unions, workers would still resist wages cuts. Even if the employers were to reduce wages, it would lead to economic depression as demand would fall and people would become more cautious about their spending. Keynes advocated that the labour markers do not function independently from the savings market. Therefore, prices and wages respond slowly to changes in supply and demand. Liquidity Trap: Liquidity trap refers to an economic scenario where there is a contraction in the economy despite very low interest rates. This contrasts with the relationship between interest rates and investment given in Classical economics. How is Keynesian economics different from Classical economics? Classical economics states that the economy self-regulates in case of a disequilibrium. Any deviations from the market equilibrium would be adjusted on its own without any government regulation. However, Keynesian economics propagates that government intervention must maintain equilibrium or come out of an economic downturn. Keynesian economics highlights the importance of monetary and fiscal policy, while Classical economics does not mention any government intervention. Another crucial difference is that Classical economics suggests that governments should always incur less debt, while Keynesian economics advises that governments should practice deficit financing during a recession. Classical economics states that government spending can be harmful as it leads to crowding out of the private investment. However, it has been later established that this happens when the economy is not in a recession. Government borrowing competes with private investment leading to higher interest rates. Thus, Keynesian economics is of the view that deficit spending during a recession does not crowd out private investment. What are the policy measures advocated by Keynesian economics? According to Keynes, adopting a countercyclical approach can help economies stabilise. This means that governments must move in a direction opposite to the business cycles. The theory also states that governments should recover from economic downturns in the short run itself, instead of waiting for the economy to recover over time. Keynes wrote the famous line, “In the long run, we are all dead”. The short run knowledge of the economy would be far better than the long run prediction made by any government. Thus, it makes sense for governments to focus on short run policies and maintain short run equilibrium. Keynes’ multiplier effect states that government spending would increase the GDP by a greater amount than the increase in government spending. This multiplier effect established a reason for governments to go for fiscal support when the economy requires it. What have been the criticisms of Keynesian economics? The initial stages of Keynesian economics propagated that monetary policy was ineffective and did not play any role in boosting economic growth. However, the positive effects of monetary policy are well established and have been integrated into the new Keynesian framework. Another criticism is that the advantage of the fiscal benefits to the GDP cannot be measured. Thus, it becomes difficult to fine-tune the fiscal policy to suit the economic scenario better. Also, the Keynesian belief of increased spending leading to economic growth may lead to the government investing in projects with a vested interest. It could also lead to increased corruption in the economy. The theory of rational expectations suggests that people understand that tax cuts are only temporary. Thus, they prefer to save up the income left behind to pay for future increases in taxes. This is the Ricardian Equivalence theory. Thus, fiscal policy may be rendered ineffective due to this. Supply-side economics has also shown contrast to Keynesian beliefs. During the stagflation in the 1970s, the Phillips curve failed, bringing out the importance of supply-side economics.

Narrow market is the market with a smaller number of buyers and sellers, and is further characterised by high price volatility, low liquidity of assets, and only few transactions occurring in the market. Due to limited number of transactions taking place, it is a common scenario in a narrow market where there are very less investors who sell and buy only particular shares.

  What is Nasdaq?  Nasdaq Stock Market is a global electronic marketplace for buying and selling securities on an automatic, transparent and speedy electronic network. It trades through a computer system rather than in a physical trading floor for the traders to trade directly between them. It is an American stock exchange located in the Financial District of Lower Manhattan in New York City. NASDAQ is owned by the company Nasdaq. Inc. and ranked second on the list of stock exchanges as per market capitalisation of shares traded. The first rank goes to the New York Stock Exchange. Nasdaq-National Association of Securities Dealers Automated Quotations, was founded in 1971 by the National Association of Securities Dealers (NASD) to avoid inefficient trading and delays. Nasdaq. Inc. company also owns the Nasdaq Nordic stock market network in addition to other exchanges. The exchange has more than 3,100 companies listed. They are the highest trade volume companies in the US market, valued more than US$14 trillion in total.  Good read: NASDAQ surged up above 10,000 – Tech stocks setting a new benchmark   What is Nasdaq known for?  Nasdaq currently is the largest electronic stock market, and it is most well-known for its high-tech stocks. But it also has a variety of companies listed such as capital goods, healthcare, consumer durables and nondurables, energy, public utilities, finance and transportation.  Nasdaq boasts of having some of the largest blue-chip companies in the world and attracts high growth-oriented companies. Its stocks are known to be volatile than those listed on other exchanges. Apart from listed stocks, Nasdaq also trades in over the counter (OTC) stocks. The ticker symbols for the listed companies’ stocks on the Nasdaq have four or five letters.  The Nasdaq Composite index was initially termed as Nasdaq. It included all the stocks listed on Nasdaq stock market and also many stocks listed on Dow Jones Industrial Average and S&P 500 Index. The index has more than 3,000 stocks listed on it which include the world’s largest technology and biotech giants like Microsoft, Apple, Amazon, Alphabet, Facebook, Gilead Sciences, Tesla and Intel.    Did you read: Blue-chip stocks: Value versus Growth in Covid-19 Era   Companies have to meet certain criteria to get listed on the NASDAQ National Market.  The entities have to meet financial, liquidity, and corporate governance-related requirements. Have to get registered with the Securities Exchange Commission (SEC) Have to maintain the stock price of at least US$1. Company’s value of outstanding stocks must total at least US$1.1 million.   The small companies which cannot meet the criteria can get listed on NASDAQ Small Caps Market. Nasdaq changes the companies as the eligibility of the companies keeps changing.  Image: Kalkine   What are different Nasdaq indexes?  Nasdaq uses an index to list its stocks like any other stock exchange. The index delivers stock performance snapshots. The New York Stock Exchange (NYSE) has the Dow Jones Industrial Average (DJIA) as its primary index; it tracks the stock price of 30 big companies. Nasdaq Composite and the Nasdaq 100 are two indices of Nasdaq. Nasdaq Composite measures the performance of more than 3,100 listed companies’ stocks trading daily on Nasdaq. Nasdaq 100 is a modified capitalisation-weighted index. This index has listed companies from various sectors, but the majority is from the technology industry. Depending on their market value, Nasdaq adds or removes the companies from its index Nasdaq 100.  Both the NASDAQ Composite and the NASDAQ 100 indexes have listed companies from the United States as well as global companies. On the other hand, Dow Jones Industrial Average index does not include companies outside of the US.    Did you read: Hanging Up Your Boots? Investment Strategies to Help you Relax and Build Wealth   Brief history  Nasdaq performance in the past has been groundbreaking and extraordinary. One of its highly regarded accomplishments is that Nasdaq was the first-ever stock exchange for offering electronic trading. It was the first to launch a website and stored all the records in the cloud. Interestingly, Nasdaq also sold its technology to other stock exchanges. Nasdaq invented the modern Initial Public Offering (IPO) as it listed venture-capital-backed companies. Initially, it merged with the American Stock Exchange. It formed the Nasdaq-AMEX Market Group, later on, the AMEX index was acquired by NYSE Euronext, and the entire data was integrated into NYSE. In 2007 Nasdaq acquired OMX which is a Swedish-Finnish financial company. Followed by which Nasdaq changed its name to NASDAQ OMX Group. NASDAQ OMX Group bought the Boston Stock Exchange and also the Philadelphia Stock Exchange which was the oldest stock exchange in the US.  Also read: Nasdaq index’s Tech Titans kicks off with Bold Performances   How to trade on Nasdaq?  Though the New York Stock Exchange is the largest exchange by market capitalisation, Nasdaq is the largest by trading volume due to its electronic quote mechanism. Nasdaq is a dealer’s market where the public buys and sells stocks with the help of the market maker (a registered broker/dealer). The market maker provides the buy and sell quotes and takes the position in those stocks. NYSE works differently as the buyers and sellers can trade directly with each other, and a specialist allows the trade. On Nasdaq, the market maker owns inventory and trade stocks in his/her capacity. Good read: Why NASDAQ Composite index plunged 5%?

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