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Liquidity refers to the ease with which an asset or security can be converted into cash without affecting its market price. In other words, it evaluates how fast and effectively a transaction may be executed without experiencing major price volatility or execution delays.
Financial markets need liquidity because it enables quick and efficient entry and exit of positions by investors. Large institutional investors who manage sizable portfolios and may need to conduct regular trades to rebalance their holdings or modify their exposure to various asset classes may find this to be of special importance.
The bid-ask spread, which measures the difference between the highest price a buyer is ready to pay and the lowest price a seller is willing to accept for an item, is one of the most widely used metrics of liquidity. Since they may be bought or sold more readily without changing the market price, assets with narrow bid-ask spreads are typically thought of as being more liquid than those with broad gaps.
Trading volume, which measures the total number of shares or contracts exchanged for a specific asset over a specific time period, is another crucial indicator of liquidity. Since they are exchanged more frequently and may be bought or sold more easily, assets with high trading volumes are generally regarded as having higher liquidity than those with low volumes.
A number of variables, such as market conditions, legislative changes, and investor attitude, can have an impact on liquidity. Liquidity, for instance, can quickly run out during times of market stress or uncertainty as investors become more risk-averse and reluctant to trade. Liquidity can also be impacted by legislative changes that limit market participants' capacity to trade or keep particular assets.
