Friday, August 24, 2007

Liquidity in Business and Markets

'Liquidity is expensive but illiquidity is much more so, because it destroys the very existence of a firm"
I don't remember if it was Johannes or Ernst, it was a long time ago that I read Manchester, quoting one of the Schroeder boys on the insolvency of Krupp. That line has stuck with me. Here's the book.

Bill Gross in his latest missive from PIMCO said:

The past few weeks have exposed a giant crack in modern financial architecture, created by youthful wizards and endorsed as a diversifying positive by central bankers present and past. While the newborn derivatives may hedge individual institutional and sector risk, they cannot eliminate the Waldos. In fact, the inherent leverage that accompanies derivative creation may foster systemic risk when information is unavailable or delayed in its release. Nothing within the current marketplace allows for the hedging of liquidity risk and that is the problem at the moment.

Alexander Campbell at Risk: Over the Counter brings us a timely paper:

According to this (fortuitously topical) paper, liquidity is hugely valuable: "a liquid asset can be worth up to 25% more than an illiquid asset, even though both have identical cash flow dynamics". Or, to put it another way, a sudden absence of liquidity could in effect mean a 20% drop in portfolio value, even if the assets - and their market prices - remain constant. Nasty.

Hold that thought while Rick Bookstaber speculates:

Lower volatility can mean higher risk. Here is how I think we get to this paradoxical result.

With the growth of hedge funds over the past few years, more and more capital has been scavenging for alpha opportunities... That is, there is more liquidity. And this is great for the liquidity demanders – for example a pension fund that has to invest a recent inflow – because they don’t have to move prices very far to elicit the other side of the trade. And that means lower price volatility. The lower volatility in turn leads to higher leverage...

And as leverage increases, liquidity rises and alpha is diluted out - which means that hedge funds have to use even more leverage to hit their targets... and so on up.

Stay liquid, stay healthy.