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Why Are Some Assets More Liquid Than Others? Explain How Information Asymmetries Can Cause Markets To Collapse/ Reduce In Liquidity.

1702 words - 7 pages

Why are some assets more liquid than others? Explain how information asymmetries can cause markets to collapse/ reduce in liquidity.Part One: When a person invests in a financial institution, the institution in turn invests this money where they see fit. Their aim: to earn interest on the money, over and above the guaranteed rate of return they have promised their clients; hence making a profit for themselves.The more money these institutions have at their disposal the better. They therefore develop a set of packages with the aim of attracting as much investment from the public, into their company, as possible. The liquidity of these assets, along with their potential return varies. To make the most gain, one must commit their money to the institution for a relatively longer period of time i.e.: reducing their assets liquidity. Investments which require more accessibility, can clearly not be invested long term by the financial institution, leading to understandably lower rates of return for this more liquid asset.Herring defined the liquidity of an asset as follows: "The liquidity of an asset depends on the percentage of full market value which can be realized if it is sold on short notice, where full market value is defined as the maximum price that any potential buyer would be willing to pay if the owner of the asset could take as much time as necessary to locate the highest bidder" Here the focus is on time, the quicker an asset can be converted into cash at its full market value, the greater its liquidity. Time is one of the main determinants of an assets liquidity but there are a variety of other issues, which determine the assets liquidity as well.The exact characteristics of the asset have an effect. The more short term the asset is, the more liquid it is as it is expected to be redeemed for cash in the very near future. An example of this would be the difference between a three-month Treasury bill and an investment into property. The longer period of time, which you will inevitably have the land for due to its lower liquidity, leaves it open to adverse affects on the market which could lower your expected return on the property. On the other hand, the short duration of a three-month Treasury Bill means there is less possibility of external factors negatively affecting the value of the asset, hence adding to its liquidity.The Bid/Ask spread is a measure of the liquidity of an asset. The greater the spread, the lower the liquidity; therefore the closer these two prices are, the more liquid the asset will be. Differences in the general level of spreads can be seen between the London and Frankfurt markets. Frankfurt's spreads are much wider showing it to be a much less liquid market then that of London.Herring discusses the relationship between quality of an asset and its liquidity. He argues that generally higher quality assets are regarded as more liquid than lower quality assets because their prices are likely to be more stable. Although...

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