What Is Liquidity?

Market liquidity refers to the degree to which a market is active. Trading volume and the number of active traders determine how much the spread costs. During the weekdays, the foreign exchange market is tradable 24 hours a day, which makes it extremely liquid. Throughout the day, nearly $6 trillion is traded in this market, making it one of the largest in the world.

Though liquidity fluctuates throughout the day due to the openings and closings of financial centers around the world, forex trading volume is generally high all day.

What Is Liquidity Preference Theory?

Lord Keynes formulated this theory in (1936), arguing that the level of interest rate depends on the interaction of two vital factors: the supply of money and the desire of the savers to hold the savings in cash.

A liquidity preference theory suggests that investors should demand higher interest rates on long-term securities carrying greater risks, given that, all other factors held equal, cash or other highly liquid assets are likely to be preferred.

A liquidity motive can be divided into three components: (1) the transaction motive, (2) the precautionary motive, and (3) the speculative motive. These motives are discussed in detail in the following section of this article.

How Does Liquidity Preference Theory Work?

According to liquidity preference theory, longer and medium-term securities command higher premiums than short-term securities. John Maynard Keynes developed this theory to prove that liquid investments can be easily listed at full value, a belief that gives them speculative power.

Liquidity is commonly considered to be the most important characteristic of cash. Short-term securities have lower interest rates than medium- and longer-term securities according to the liquidity preference theory because investors do not sacrifice liquidity for longer timeframes.

Special Considerations

The General Theory of Employment, Interest and Money introduces the Liquidity Preference Theory. In his theory, Keynes describes three motives that determine the demand for liquidity. These include:

Transaction motive: it states that individuals prefer liquidity to ensure having enough cash on hand for basic needs on a daily basis. Basically, stakeholders need liquidity to purchase groceries, pay rent, and borrow money to cover their short-term obligations. Having higher living costs means a greater need for cash and liquidity to cover those needs on a daily basis.

Precautionary motive: refers to a person’s wish to have additional liquidity in case an unexpected issue or expense arises requiring a considerable amount of money. Costs such as car repairs or house repairs are often unforeseen.

Speculative motive: There is also the possibility that stakeholders are motivated by speculation. The demand for cash is high when interest rates are low, so investors may prefer holding assets until interest rates rise. An investor who possesses a speculative motive is afraid, for fear of losing out on an alternate opportunity in the future, of tying up their capital for investment.

The higher interest rates mean that investors give up liquidity to obtain higher interest rates. The investor might sell the low-paying bonds and buy higher-paying bonds at a time when interest rates are rising or hold onto the cash to wait for a higher rate of return.

For predicting future rates, this theory includes a concept called risk premiums or liquidity premiums. Although the term structure (the formula defining the yield curve) of interest rate contracts is mostly substitutable for various maturities (a ten-year bond can substitute two consecutive 5-year bonds), a risk factor causes the yield curve to be upward-sloping for most of the time. The yield curve would still slope upward even if the interest rate expectations were the same across the entire spectrum of maturity due to the inherent risk of acquiring a longer-term debt instrument.

Increasing the maturity date of repayment increases the risk premium, because long-term interest rate contracts tend to be less liquid than short-term ones. Because long-term instruments are less marketable, they are also less liquid, and this leads to higher interest rates over time.

Assuming all investors have similar preferences, the risk premium assumes they will demand additional compensation for higher risk at higher maturities, for practical and easy to understand reasons. Isn’t it possible that not all investors value every segment of the maturity structure equally? Alternatively, how about assuming that there is inherent, qualitative difference between maturities that investors perceive so differently that these various maturities cannot be substituted one for the other in the role they play in investor portfolios?

The liquidity preference theory is basically an improved version of the pure expectations theory. In addition, it recognizes that different maturities are partially substitutable but not completely so, as the former postulate. Long-term and short-term debt instruments differ in terms of qualitative properties, as quantified by their risk premium, which is evident on the sloping upward curve, and in the observed phenomenon of higher interest rates at longer maturities.

Example of Liquidity Preference Theory

Treasury notes for three years might pay 2% in interest, Treasury notes for ten years might pay 4% in interest, and Treasury bonds for thirty years might pay 6%. In order for the investor to sacrifice liquidity, they must get a higher return in exchange for the cash being tied up for longer periods of time.

All things considered, liquidation preference theory protect preferred investors from downside risks. When a liquidity event occurs, investors have the choice of either receiving their liquidation preference as a return, or converting them into common shares and getting their percentage ownership.