Okay, so we know that liquidity is important, and that its disappearance causes corporations grief. So let's take a closer look at what is liquidity and how it is determined. So first, it might be worthwhile to distinguish two types of liquidity. Corporate liquidity we've seen in the previous course, the accounting rules. We've seen that corporate liquidity could be defined as how quickly a firm can engage in financial transactions, can sell it's assets, for example, by issuing money market securities, to cover a mismatch, or to actually pay for a debt. So financial statements, as you've seen in that first course, distinguish assets and liabilities on their currency, current versus non current. And the distinguishing feature there was whether they're due within a year or beyond one year. We distinguished debt definition of liquidity from investor or market liquidity. Investor or market liquidity is defined as how quickly an investor is in fact able to liquidate its holdings, it's possession of an asset by selling to other investors, not only just earned asset but a large volume of assets at a fair value. So without impacting their price on the secondary market. So let's get into these measures of market liquidity. Where market liquidity as we've just seen is the ability to transact large asset volumes very quickly without changing the price by too much. The dimensions we look at are the following. First, there's tightness. Tightness captures the transaction costs involved when you buy the asset and subsequently sell the asset. Even if you do that almost instantaneously, you will incur a cost for using the market, for making use of the services of the specialist, or the market maker or the dealer. We could call that bit as breadth, and we'll see that in a moment. Second, dimension immediacy, making sense, we want to be able to offload a large volume of the assets quickly. Immediacy would capture the speed at which we can do that. So, the speed of order execution. Then, third dimension is depth. And depth measures the abundance of orders. Orders to buy at a variety of prices stack up against orders to sell. Depth measures again the ability of an investor to offload a relatively large partial of assets, without changing prices too much. Breadth measures the size of individual orders at various prices. And lastly on the list, resiliency. Resiliency capturing the price impact of a large volume order away from its fundamental or intrinsic value. Imagine that an institutional investor wants to sell a million shares in a particular company. That inevitably causes a significant supply shock to the market, which could mean that the price would drop. In a resilient market, we would hardly notice the impact of such a large transaction. These dimensions of liquidity are measured by a large number of metrics to get a feel for depth, resiliency, etc. So the list there is far from exclusive. But typical metrics we look at are volume, the size of transactions, the number of transactions, turnover, how often is a share traded, bid-ask spreads - what is the difference between the price at which you can buy and the price at which you can sell an asset on the market? And lastly here, volatility. The typical variation in prices. All of these metrics tend to be highly correlated so it doesn't really matter which one you choose, except when things go wrong. So in these financial crises, that we just touched on, all of a sudden, some of these metrics are telling their own story, which differs from other metrics. So we'll have to take a closer look at those metrics when we consider these market failures. So here is a summary of some of the metrics that you've just seen of market liquidity for a company, Kellogg's, compared to a competitor of Kellogg's, Mondelez, starting with the bid-ask spread. The bid-ask spread is defined as the difference between the price at which you can buy an asset, the ask price, the price asked by the specialist on the New York Stock Exchange for example. And the bid price, the price that the specialist is willing to pay you if you sell the asset. So for Kellogg's the ask price is $64.90. You can buy a share in Kellogg's for $64.90, and you can sell on the same market, that share for $63.39. The difference between buy and sell price is $1.61. That is the bid-ask spread. If we do the same for Mondelez, we see that its bid-ask spread is $1.99. So it is more expensive to do a round trip transaction in Mondelez share than it is to do that same round trip transaction in Kellogg's shares, but that's not the entire story. For that reason we also look at percentage bid-ask spread. Because you might notice that in the video shares in Kellogg's, Kellogg's are considerably more expensive than the individual shares of Mondelez. Where as Kellogg's trades for about $64, Mondelez is trading for about $39. So we can express the bid-ask spread of $1.61 for Kellogg's in terms of the average price. The average between bid and ask price, and we see that that translates into a percentage cost. For Kellogg's that translates into a percentage cost of 2.4% of the midpoint price. For Mondelez that is 5.1%. So the story is the same, but it is now adjusted for the share price. It is cheaper to transact in Kellogg's shares than it is to transact in Mondelez shares. The next metric we look at is average daily volume, and average daily volume is here, defined as the number of shares traded. We could also measure volume in dollar terms, but we don't do that here. On a typical day, it is an average measured over the last three months. On a typical day, 2.2 million shares of Kellogg's change hands. For Mondelez that is 10.79 million shares. So liquidity, as measured by averaged daily volume, is considerably larger for Mondelez. Again, we need to put it in perspective. And for that reason we look at how many shares are there actually available for trading on the New York Stock Exchange for both companies. And we see that the float for Kellogg's was 257 million shares outstanding, whereas for Mondelez it is 1.59 billion shares outstanding. Debt gives us the opportunity to compute a turnover metric. Where the turnover is defined as that number of shares outstanding, the float, divided by the typical daily volume traded in those shares. And that would give you an idea of how many days it takes before a single share gets traded again, gets turned over. For Kellogg's that boils down to 117 days. For Mondelez it would be 147 days telling you something about, again, the immediacy, the speed at which shares get traded on the exchange. And lastly the metrics taken here is one of the ownership by institutional investors in the shares of those two companies. They're not that dissimilar but we can see that the institutional ownership share for Kellogg's is 73% whereas for Mondelez it is 78%. That share gives you an indication of institutional share ownership, which is typically not as liquid as retail investors ownership. So it is an indirect measure of the liquidity or illiquidity of trading in those two shares. So what is driving these metrics? What is determining their value? What determines liquidity? We distinguished two sets of factors contributing to liquidity. First, there are the market related factors, the microstructure factors. Liquidity will depend on the traded asset design. How liquid, how substitutable is a particular asset that will enhance, the more substitutable the asset, the more liquid it will be. It will depend on the market participants. Are the shares totally held by institutional investors? Or are there lots of retail investors that continuously trade in these securities and create liquidity to assist in price discovery? It'll depend on trading systems or trading platforms. Internet trading has significantly enhanced liquidity, making it that much easier for investors to access these markets on a real time basis. Then there's trading rules. If there are tight restrictions on transactions, on exchanges, on markets then that will hamper, will make transactions in those assets that much more illiquid. Clearing and settlement procedures will also assist in liquidity of the assets traded. And last, but certainly not least, the regulatory framework. Is there a significant regulatory imposition thereby hampering liquidity, scaring away certain types of investors, that might be for good reasons but it might also have a negative impact on liquidity. So those are all the factors that directly stem from the market that we consider. Next to that is a set of macroeconomic factors. Economic stability, monetary policy stability, legal enforcement within particular jurisdictions will have a direct impact on the liquidity of that jurisdiction of that country's markets and need to be considered when we assess liquidity. The metrics we've just seen capture observable liquidity. But there's also something called hidden liquidity. Block trades, for example, having been around for a long time on exchanges, capture off market institutional investors transactions. Very large transactions that would almost inevitably have a large price impact, thereby impacting on the resiliency of the market. So the volume of those transaction accounts for almost more than 40% in the U.S. alone. So it's a significant component of overall liquidity, but we don't see it. And then there is the more recent phenomenon of dark pools, where private exchanges, private forums, transact these large block trades entirely off market. So not just in the corridors of the market, but in fact on entirely different trading platforms. Just to give you an example of the impact or the relevance, the importance of these dark pools, more than 10% of London equity trading volume is alleged to be transacted in these dark pools. In the US, it's even up to 15% of total US equity trading volume. So this is a significant component of liquidity but it is not accessible to all. So why do these dark pools, why do the block trades occur? Well simply because they promise better execution. Execution at prices which would be closer to the intrinsic value of the assets avoiding the problem of price impact. Lower transaction costs as well. These new platforms concentrate trading more. Typically what you'll see is that the bid-ask spread is narrower for the dark pools and for the block trades. Direct benefit for the institutional investors for the large traders, but of course there's also a flip side to the dark pools, and that is one of a lack of transparency. They're called dark for a reason. We don't actually observe the transactions that occur on those markets. The amount of buy and sell orders available in the dark pools as block trades are typically not observed by the public at large. So it causes a lack of transparency. They're also vulnerable to a conflict of interest, whereas the public exchanges are clear about the role of dealers and specialists, that is not so obvious for the dark pools. And most importantly, and more recently, retail traders are moving into these dark pool areas as well. Is that a smart move? Is that clever from the perspective of markets that are, by and large, unregulated? That's a question yet to be addressed. So back to observable liquidity. What happens when it evaporates? What happens when it's gone? Well we've already decided depth happens exactly when the market is under duress. When market stress occurs, liquidity tends to disappear. When it is most needed, liquidity actually exits. So deteriorating liquidity meshes as we would captured them with these metrics, indicate an increasing like of investor interest. Typically first, all those that would be buying assets disappear, but then the sellers are disappearing as well, and they would just bide their time. Depth and breadth disappear altogether from one side of the market, but ultimately from both sides of the market. At that stage prices become unreliable signals of true, fair, intrinsic failure. Market structure may in fact change so moving from electronic trading to dealers platforms altogether. So where as internet trading platforms, automated trading platforms were established to increase liquidity, when the markets are in stress, when liquidity disappears, these platforms are becoming obsolete and investors are actually resorting to the dealers driven market. Over-the-counter markets all of a sudden gain an importance again. That can only mean the transparency is disappearing from the market and the market fragments. An overall bad outcome. So here's an example of one such liquidity crisis. The demise of Long Term Capital Management in 1998. Arbitrage and speculative trading strategies used by LTCM backed up by quantitative finance specialists assumed that liquidity would always be there, in good times and bad times for markets. That would allow initially misaligned prices to ultimately return to their fundamental intrinsic value. But what happened in fact was that illiquidity did occur. Illiquidity in fact, was coursing the misalignment of the prices. So the transactions that occurred were done at prices away from the intrinsic value. But given that they were caused by illiquidity, LTCM was unable to subsequently complete the transaction because prices were, in fact, persistently driven away from their intrinsic value. And then of course there's the global financial crisis, but more of that in a few lectures.