An Operational Measure of Liquidity

Abstract

The purpose of the article is to present a precise definition of liquidity in terms of time until an asset is exchanged for money. It shows that this definition is compatible with several other useful notions of liquidity. Whereas academic economists do not possess a definition of liquidity as a measurable concept, other workers in the area casually respond that liquidity is the length of time it takes to sell an asset. Thus, cash is considered the most liquid asset, while stocks listed on the New York Stock Exchange are viewed as more liquid than collectibles, precious metals, jewels, real estate and capital goods. The problem with this view of liquidity is the lack of precision and casual reference to the length of time it takes to convert the asset into cash. The approach suggested in the article incorporates this idea as it consists in embedding the sale of the asset in a search environment, discerning a sales policy that maximizes the expected discounted value of the net proceeds associated with the sale and defining the asset's liquidity to be the expected time until the asset is sold when following the optimal policy.