Illiquid

Illiquid Meaning

Illiquid refers to an asset that cannot be quickly converted to cash. Such assets suffer a valuation loss when they are sold in exchange for cash. Bonds, stocks and properties are some examples of an illiquid investment. In other words, it is an uphill task to sell such assets owing to the utterly low trading activity due to a lack of investor interest.

Explanation

Due to a low trading volume, illiquid assets tend to have a wider bid-ask spread. When there is a huge difference between what the seller quotes as the asking price of an illiquid asset and what the potential buyer is willing to pay, it results in a wider bid-ask spread.

This happens because of the absence of readily available markets for such assets. Sometimes, the insufficient market depth and lack of willing buyers lead to significant losses for the owners of the illiquid assets.

Illiquid

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Some examples of Illiquid Assets

  • Bonds and stocks
  • Real estate properties
  • Motor vehicles
  • Antiques
  • Investment in privately held companies
  • Shares of small-cap companies
  • Various types of long-term debt instruments
  • Some of the collectables and art pieces

All these items indeed have a certain intrinsic value, but there is a sizeable amount of money required in their purchase. Moreover, investors often develop cold feet at the mere thought of having their money locked up for a long time in such investments. Together, they often dissuade investors or buyers from making such investments.

Why Invest in Illiquid Assets?

The answer to this question is simple. Sacrificing liquidity is considered as a sound investment strategy by some investors who hope to reap a relatively higher yield in future. Therefore, the possibility of high earnings can compensate for the inability to trade easily.

So, how much extra return can justify such types of investments

As there are no thumb rules for the extra return, it purely depends upon the type of investment security and its extent of illiquidity. For instance, small-cap stocks exhibit erratic trading volumes at the exchange, which makes them illiquid. So, the investors try to buy these small-cap stocks at a lower price-to-earningsPrice-to-earningsThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. read more (PE) multiple and earn a higher return on investment.

While making investments in privately held companies that don’t trade on any exchange, the investors ask for higher risk premiums. Mostly, professionally managed funds with a long investment horizon invest in these companies. As such, the investors have limited freedom to move out of the investment before the funds’ maturity.

Illiquid and Risk

Illiquid securities come with an inherent riskInherent RiskInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization.read more, which leads to liquidity risk. The investor learns of the risk when the market is extremely stressed. In such a scenario, the equilibrium between the number of buyers and sellers goes haphazard. Owners find it difficult to sell off their assets without significant losses. Therefore, the buyers often seize the opportunity by charging heavy liquidity premium to compensate for the limited liquidity.

Benefits

Limitations

Aside from the liquidity risk, these assets come with more risks for their investors. The liquidity premiumLiquidity PremiumLiquidity premium refers to the extra compensation desired by the investors for holding assets that are either difficult to be converted into cash or tradable in the open market at a fair price.read more offered on an illiquid asset is too low. Also, the provisions created against these investments take away a significant portion of their value.

Key takeaways

  • Illiquid assets suffer from a valuation loss when they are sold in the market in exchange for cash. Some examples of such assets are stock, bonds and properties.
  • The investors need to exercise caution as they come with liquidity risk.
  • Such assets earn higher returns in future which compensates for the liquidity risk.

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