Liquidity is the ability to convert an asset into cash. Liquidity and [[Optionality]] are inversely related because the less liquid an asset is, the more the options on that asset are worth. ## Volatility is the Price of Liquidity Realized and Implied volatility increase when investors rush to increase their liquidity. When there is a market panic prices fall, implied volatilities increase, and realized volatility increases. Liquidity is dependent on the number of participants willing to value an asset. The larger the audience the more liquid an asset will be. However, if the entire audience is going in the same direction liquidity can suffer. On the downside you will experience difficulty selling the asset as no bidders can be found and price must adjust rapidly to lure new buyers into the market. On the upside the competition for the asset can be fierce and it can be difficult to buy enough of the asset. ## Directionality Volatility is an abstract market concept; you can't touch it or feel it, but you most certainly experience it. There is a strong directional component to liquidity and volatility. In a rising market you will tend to see volatility decrease but also upside skew increase. Alternatively, in a falling market you will see volatility and skew increase together. Liquidity decreases towards the end of an auction and price movements get exaggerated ultimately leading to excess and the end of the auction, but in a rising market it is typical to see lower liquidity associated with lower volatility but increased call skew. ## Private Markets Private markets boast low mark-to-market volatility because they can mark their assets infrequently and the market for the assets is small and since there is not a readably observable price for the asset they can mark the asset using a valuation model. This creates an anomaly in the perception of these assets. Since we know that the less liquid an asset is the more the options are worth and we know that volatility is the price of liquidity, we would expect the options on these assets to have a high implied volatility. However, since there are no options on these assets investors are able to carry these investments and demonstrate high Sharpe ratios because the real volatility is understated by the mark-to-model volatility. **Case Studies** - [[CHG Issue 192 The Siren Song of Liquidity]] - [[CHG Issue 189 Private Credit Crisis]] - [[CHG Issue 160 The Price of Liquidity]] - [[CHG Issue 148 Unpacking Investment Vehicles]] - [[CHG Issue 145 Liquidity Crashes]] - [[CHG Issue 143 Finding Order in Disorder]] - [[CHG Issue 8]] Explore Further: [[CHG Risk Factors]] Tags: #evergreen Your support for Cedars Hill Group is greatly appreciated <form action="https://www.paypal.com/donate" method="post" target="_top"> <input type="hidden" name="hosted_button_id" value="74PGN8ZXHQVHS" /> <input type="image" src="https://www.paypalobjects.com/en_US/i/btn/btn_donate_LG.gif" border="0" name="submit" title="PayPal - The safer, easier way to pay online!" alt="Donate with PayPal button" /> <img alt="" border="0" src="https://www.paypal.com/en_US/i/scr/pixel.gif" width="1" height="1" /> </form>