Wednesday, April 8, 2009


In an economy with a single medium of exchange, "liquidity" of anything else represents the ability to convert that else into that medium. If I have two assets, one with a 5% bid-offer spread but very stable, the other more tightly bid but very likely to drop well over 5% before I'm looking to convert the asset to something else, it seems to me the former better serves any needs that tend to get lumped under the term "liquidity". This is how I model it mentally, is as a softish lower bound on the price for which I could sell it if the value of money to me (and its associated discount rate — i.e. where selling today might be better than selling at 1% more tomorrow) were to spike.

Stock price volatility tends to increase as stock prices drop, and this is usually couched in terms that suggest the latter causes the former, but it kind of makes more sense that it would run the other way: part of the value of stock is its "liquidity", i.e. one's ability to convert it, at little notice, into cash should that be necessary. When uncertainty increases, that, other things equal, is going to reduce the value of the stock.