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Liquidity refers to the volume of trades in the market. It is the ability to exchange currencies without really affecting the price of the pair. The more liquid a currency pair is, the less impact buys and sells actions will have on its price.

Key Takeways

  • Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price.
  • Cash is the most liquid of assets, while tangible items are less liquid. The two main types of liquidity include market liquidity and accounting liquidity.
  • Current, quick, and cash ratios are most commonly used to measure liquidity.

Understanding Liquidity

In other words, liquidity describes the degree to which an asset can be quickly bought or sold in the market at a price. Therefore, reflecting its intrinsic value. Cash is universally considered the most liquid asset because it can most quickly and easily be converted into other assets. Tangible assets, such as real estate, fine art, and collectibles, are all relatively illiquid. Other financial assets, ranging from equities to partnership units, fall at various places on the liquidity spectrum.

For instance, if a person wants a Ksh.20,000 refrigerator, cash is the asset that can most easily be used to obtain it. If that person has no cash but a rare book collection that has been appraised at Ksh.20,000, they are unlikely to find someone willing to trade them the refrigerator for their collection. Instead, they will have to sell the collection and use the cash to purchase the refrigerator. That may be fine if the person can wait for months or years to make the purchase, but it could present a problem if the person only had a few days. They may have to sell the books at a discount, instead of waiting for a buyer who was willing to pay the full value. Rare books are an example of an illiquid asset.