Illiquid as a term, is used to identify assets or securities that cannot be disposed of quickly by way of sale. Also, it refers to a business/enterprise that doesn’t have enough funds to meet its obligations. The illiquidity of the business may lead to bankruptcy because — as a company can exist without profit but not without funding for operations.
A Little More on Being Illiquid
Illiquidity is a business terminology that refers to a firm that lacks enough cash flow to make payments for their debt. Although the company has other fixed assets like machinery building and land, these assets are illiquid and selling them is not a core part of the business operation.
Selling of illiquid assets only arises in time of severe financial crisis; however, if not done on time, there will be a likelihood of a fire sale, whereby the asset fetches lower price compared to prevailing market valuations.
Illiquid assets usually attract large differences between ask price, set by the seller, and the bid price, submitted by the buyer. With larger spreads than in a competitive sale, the illiquid asset typically loses value in a quick deal.
The loss is due to the company having a limited alternative due to lack of purchasers for value or willing investors to take up the asset.
Nevertheless, the liquidity of such assets changes with market influence; for instance, collectibles items value may fluctuate over time due to popularity.
Several assets can be classified as illiquid because they are not commonly traded;
- Over-the-counter (OTC) markets Stocks such as; penny stock, nanocap and microcap stocks.
- Shares in private companies.
- Houses and other real estates
- Collectibles such as antiques and classic arts.
- Partnership shares in hedge funds.
- Some types of bonds and debt instruments.
- Also, some types of futures, forward contracts, and options.
Determining the real market value of these assets may be challenging.
Liquid assets, on the other hand, can easily be disposed off by way of sale during a regular trading hour and will often attract the current market value. Examples include;
- Listed stocks.
- Mutual funds.
- Commodities listed for exchange.
- Precious metals (gold and silver)
Trading these assets other than during regular market hours may lead to illiquidity since there is minimal market participation and trading is inactive; therefore it’s hard to make a sale.
References for Illiquid
Academic Research on Illiquid
- Illiquidity and stock returns: cross-section and time-series effects, Amihud, Y. (2002). Journal of financial markets, 5(1), 31-56. The paper explains how overtime illiquidity affects stocks using research on time series and cross-section effects.
- Market microstructure and asset pricing: On the compensation for illiquidity in stock returns, Brennan, M. J., & Subrahmanyam, A. (1996). Journal of financial economics, 41(3), 441-464. The paper looks at research on the measure of illiquidity of stocks for intraday trading and the empirical relationships available.
- An econometric model of serial correlation and illiquidity in hedge fund returns, Getmansky, M., Lo, A. W., & Makarov, I. (2004). Journal of Financial Economics, 74(3), 529-609. The paper discusses, using a sample of 908 hedge funds obtained from the TASS database, the relationship in similar returns achieved from hedge funds and other alternative investments using an econometric model of serial correlation and illiquidity in hedge fund returns.
- The illiquidity of corporate bonds, Bao, J., Pan, J., & Wang, J. (2011). The Journal of Finance, 66(3), 911-946. The author employs the use of transactions data from 2003 to 2009, and tries to show in the article that the illiquidity in corporate bonds is significantly higher in contrast to a bid-ask spreads explanations.
- The effect of market segmentation and illiquidity on asset prices: Evidence from exchange listings, Kadlec, G. B., & McConnell, J. J. (1994). The Journal of Finance, 49(2), 611-636. The paper presents the effect of market segmentation and illiquidity on asset prices by examining evidence from exchange listings in the New York stock exchange and the changes in share values.
- The illiquidity puzzle: theory and evidence from private equity, Lerner, J., & Schoar, A. (2004). Journal of Financial Economics, 72(1), 3-40. The paper tries to explain how managers can use the liquidity of securities as a choice variable for investment choices and presents assumption to be implemented to ensure funds give a positive market performance.
- Fear of fire sales, illiquidity seeking, and credit freezes, Diamond, D. W., & Rajan, R. G. (2011). The Quarterly Journal of Economics, 126(2), 557-591. The paper proposes an alternative way of mitigating bankruptcy in the banking sector to ensure that the system is free from fear of fire sales during a financial crisis.
- Conflicts of interest and market illiquidity in bankruptcy auctions: Theory and tests, Strömberg, P. (2000). The Journal of Finance, 55(6), 2641-2692. The article investigates the Conflicts of interest and market illiquidity in bankruptcy auctions and examines both theory and tests on bankruptcy using data from 205 Swedish firms.
- Illiquidity or credit deterioration: A study of liquidity in the US corporate bond market during financial crises, Friewald, N., Jankowitsch, R., & Subrahmanyam, M. G. (2013). In Managing and Measuring Risk: Emerging Global Standards and Regulations After the Financial Crisis (pp. 159-200). The paper investigates liquidity in the United States corporate bond market using a unique data set covering more than 20,000 bonds traded from 2004 to 2008 and whether economic impact of the liquidity measures is significantly more substantial in periods of financial crisis.
- Illiquidity, consumer durable expenditure, and monetary policy, Mishkin, F. S. (1976). The American Economic Review, 66(4), 642-654. The article discusses the relationship between Illiquidity, durable consumer expenditure, and monetary policy in the United States.
- Illiquidity component of credit risk, Morris, S., & Shin, H. S. (2009). Pap., Princet. Univ. The paper discusses illiquidity as a component of credit risk and how available kinds of risk vary with balance sheet composition off a financial institution.
- Illiquidity and interest rate policy, Diamond, D. W., & Rajan, R. G. (2009). (No. w15197). National Bureau of Economic Research. The paper looks into the relationship between short-term interest rates and bank risk for financial institutions in the United States and Europe.