Market Lquidity

In the last post I was focused on the behaviours and states of firms with respect to this measure of liquidity.  In this post I will shift focus to the market for securities. 

With the Coasean definition of the firm clearly in mind, it is important to see the relationship between firms and markets.  Firms are economic spaces where various efficiencies make production inside the firm more worthwhile than sourcing the product directly from the market.  But firms need markets for their survival.  They source materials and funding from marketplaces.  They sell their own products on markets.  They are non market entities in a sea of markets.

But markets themselves aren't actors in the sense in which a firm is an actor.  A firm has projects, has responsibilities, obligations, fiduciary, legal, creditor obligations.  Yet markets themselves can be characterised by measures of liquidity too.  Any given market, at various times, can reasonably be characterised as more or less liquid than it was, or in comparison to other markets.  If is often the case that relative market liquidity is stable enough for there to be a more or less natural ranking of markets in terms of their liquidity. 

So, for example, cash markets are considered usually the most liquid.  This is not an economic axiom, it just usually happens to be the case.  Next there are so-called cash-like markets (certificates of deposit, sovereign bonds and so on)  Each market in isolation can experience moves of liquidity on its own terms, through time.  There is, if you will, a variance on the standalone liquidity of the market.  Each market will have its own long term (normal) liquidity level, and its own variance.  As well as the 'in isolation' metric, each of these markets can be compared to each other to rank them in terms of most to least liquid - this rank order whilst not immutable, is often a stable ranking.  The ranking is a ranking of the mean liquidity.  The variances themselves could be ranked too, as could their volatility of volatility.  All three resulting rankings would be interesting and would probably usually correlate well with each other.

It is, of course, the degree to which this stability breaks down which is often the primary focus of a liquidity analysis.

The collective opinion of market participants is what ultimately drives not only the relative liquidities of the various markets  but also the fate of firms during periods of so-called illiquidity,  since it is bond holders and other creditors through capital markets which can determine the demands on a firm with respect to liquidity.  Clearly many markets are, at any given time, more or less similar to each other (Vodafone and Telecom Italia equity markets, for example are more similar than a Shell dividend swap is to a Japanese asset swap).

In the next posting, I look at what it is about certain markets, what attributes they have which drives this opinion of market participants.

Firm Liquidity

Liquidity is a slippery topic.  First of all, there isn't much official financial maths behind it.  Second, it often crops up in discussions differentiating organisations which are insolvent versus those which are merely illiquid.  The argument goes like this: we (the person, the firm, the market, the economy, the geographic region, the world) are in a moment described as solvent-but-illiquid (SBI).  This is a strange state to be in.  The distinction leads Walter Bagehot to suggest that, for central banks, there are certain solvent-but-illiquid moments for banks which need central bank action to provide liquidity at a cost to good banks.  This behaviour is often referred to as being the lender of last resort (LLR).

But just what is this moment?  Let us identify the other two states which a firm might find itself in as solvent-and-liquid (SAL), which one presumes is the healthy state.  Then there is insolvent, period.  It makes no sense to distinguish insolvent and illiquid from insolvent but liquid.  The state of being insolvent clearly dominates both.  This state is then I.

So we find firms mostly living in a world of SAL until the company fails and finds itself in the I state.  The bankruptcy laws of most legal jurisdictions determine the dominance of the I state.

Notice though that even here there are subtleties to the rather simplistic model above.  Corrupt firms may be allowed to survive by cronies in positions of power beyond the point of I.  There's a moral and a legal dimension to this, which is not the subject of the current posting, so let me ignore it for now.  But there's certainly a practical element here.  If by any means, fair or foul, a company can be said to still be able to function for a period while any expected independent accounting audit of its books would reasonably conclude that it is bankrupt, the point remains that firms can be 'technically' insolvent yet remain in business.  That subset of technically insolvent firms may be reasonably classified as additionally either liquid or illiquid.  So perhaps IAL and IBI are both worth considering.

Furthermore, even after a company goes bankrupt, that process itself is a period during which levels of liquidity may vary.  Measuring liquidity may not stop just because a company has been declared bankrupt.  Part of the process of restructuring, indeed, revolves around estimating the new organisation's expected short medium and long term liabilities and the new structure must aim to allow for sufficient liquidity to allow those liabilities to be met.

So in general liquidity is a valid measure across all states of the firm.  There are finally those states of a firm where the firm literally ceases to function as a firm - it simply dies as a meaningful economic entity.  Let us call that state D.  STate D is the state where liquidity no longer matters.

SAL, SBI, IBL, IAI and D are the main categories into which entities can be said to fall for the purposes of liquidity.  Next I will talk in general about liquidity and the market.

Liquidity

Liquidity refers in several different ways to the degree to which a person or organisation can transform securities of one type into securities of a more generally or widely accepted type.  This sounds vague, but I wanted to start my examination of liquidity by stating it thus.  

Next, I'd like to point out that any security in the world can be liquid at one moment and then later can be illiquid.  Third, I'd like to state that liquidity can be considered a ranking measure applied to all assets, from most to least liquid and that this ranking is context dependent.

The context can be time-specific (what now is liquid may not be liquid tomorrow; what now is illiquid may later be perceived as liquid), market-specific (the market associated with a particular security can have its own liquidity measures), holder-specific (what may be liquid to you because you only own one unit may be dramatically less liquid for me, if I own a large fraction of the amount outstanding of the security) and scenario-specific (holdings may be considered liquid under certain 'normal' market conditions by simultaneously less liquid under others - e.g. in a forced sale).  In this last case there is sometimes a real need or an imagined need to perform the transformation to perform some obligation.  Two examples of this are when a bank run occurs and the institution struggles to transform its assets back into cash to meet lender cash requirements; and when investors in hedge funds demand the return of their capital or regulators of those hedge funds demand to see how the manager could plan to liquidate its assets under management in a way which satisfies investor demands.

Finally, in estimating the liquidity of an entity's set of holdings, there may or may not be any additional liquidity constraints in place, which would alter the liquidity profile of those assets - I'm thinking here of clauses in hedge fund offering memoranda to investors which aim to remain fair of the average investor at all points during a forced unwind.

At its most general, liquidity is a relative measure between two arbitrary securities.  But, rather like the extension of the capital asset pricing model by Sharpe to the concept of a correlation between a security and the market index, it is convenient to consider all of these relative liquidity reads to be between the security in question and the single most liquid instrument, often considered to be cash in the local currency of interest.

One perfectly acceptable result of a liquidity analysis is a simple ranking of securities where the ranking is in effect for a known period of time.  Another is an arbitrarily scaled measure, with 0 occupying the value associated with the currently most liquid security.   This is like the ranking approach, but with the distances between securities having a common method of interpretation.   These two can be applied at the level of the market.

A third, appropriate only at the holding level, per security, would be a quadruple of fraction sold, time period, percentage cost (what fraction of the asset value will be lost in performing this transform at this time and in this size), constraint set (which a common theoretical target liquidity asset being cash in the local currency).  Let me explain all  four parts.

For a given constraint set (e.g. the company needs to raise 1,000,000 GBP in the next 4 weeks to meet a bond coupon payment; a hedge fund needs to satisfy an investor stampede to the exits, which means that a gating schedule sets up a demand schedule for cash over the coming 6 months), a company can examine its holding set and decide to fix two of the three remaining dimensions, and examine the effect on the third.  It could, for example fix the fraction sold to be 100% and the percentage cost tolerance to be <1% then see how long it would take to sell all the holdings of the asset.  It could, alternatively, hold the time to be <1d and the fraction to be again 100% and see just how much the percentage cost tolerance increases.  Thirdly, it could keep the cost tolerance at <5% and the time to be <1d to see how much they could sell of their holding set.

discounting cash flow

Companies have been valued using something like discounted cash flows (DCF) for quite a few decades now.  In the field of equity analysis, this has become something close to a standard approach.  Equity analysts would also have you believe that this is not enough, and that their 'special sauce' is what adds value to an opinion free valuation.

Buf if the theory of coherent arbitrariness is true, then perhaps the DCF approach can be bettered?  Or certainly better understood.  The essence of the DCF approach is that you imagine all the major epected cash flows that arise during the future life (or next few years) of the company.  You then find the net cash flows (that is, you balance off the incoming with the outgoing expected cash flows and consider what remains) all in a way which respects the time value of money - that is, which performs a discounting operation on those cash flows, at the appropriate level of discounting.  The present value of these net cash flows is then considered to be the fair value of the equity of the company (regardless of whether this company is listed or not).

Coherent arbitrariness states that we humans are useless at coming up with absolute (cash based) fair values, but at least somwehat better at deciding of one value is greater than another - relative valuations. 

Imagine this is also true with respect to DFC.  When you break DFC analysis down into its consituent parts, there are essentially two operations being performed.  First, the correct collation of all the relevant cash flows.  These are future cash flows, so there is some guesswork going on here.  Some of those  cash flows are easier to collate than others.  For example, debt payments are quite well defined.  Expected sales aren't.  Expected sales depends on an opinion on growth (or contraction) of that market, and the likely execution of operational and strategic factors, ranging from upscaling new plant to integrating new mergers.

Under coherent arbitrariness, this is all largely making a stab in the dark.  The part which relativises the set of expected cash flows is the choice of the discounting factor.  The discount factor turns what is a cash flow based analysis into a relative one, since the discount factor chosen is often so opinion based and variable that it essentially makes the cash flow analysis meaningless as a single company analysis.  What you're doing really is making a set of industry predictions which are encoded in relative discount factors.  You are then giving yourself so much room in these relative discounting factors that the cash flows themselves lose their stand alone predictive value and become a set of very loose constraints on what is essentially a relative value estimation.

The cash flow analysis ought to be commoditised and available as a release of the corporate finance department.  This then can be a common basis for the equity analyst to make what-if adjustments to the relative discounting factors, and the cash flows, if they really feel strongly about it.

Contingent cash flows - for example, the expected sales figures, ought then to become a kind of bond call option, presented to the equity analyst to apply or override the volatility and possibly the strke.  All aspects of the estimation process ought to become real options or fixed income based.  Analysis can then more honestly be focused on the relative distribution of parameters to these financial instruments.  Modelling a company then becomes the act of taking an agreed reference model and then setting real options parameters to it.  The analyst community should jointly construct and share the set of real options which define any specific company.

In short my suggestion is to, for better or worse, to make each company become described by a single commulity based reference model of financial instruments, including real options.  Then reveal equity analysis as a two part operation - the discovery of this community agreed set of instruments - together with a set of clearly defined parameters for these options.