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Nematrian Reference Library

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Introduction "Liquidity is the ability of a market to absorb a large number of transactions without dramatically affecting price. The absence of liquidity for an asset implies difficulty in converting it into cash, and generally reduces incentives to hold the asset, unless a countervailing premium is offered. Liquidity is to markets as oxygen is to humans - only noticeable by its absence. Defining liquidity is certainly one of its easiest aspects, though even this is not necessarily easy to do in all markets, or for all instruments. It is much harder to theorize and demonstrate what underlies liquidity, and just as hard to measure it. In this brief review of extant working papers, we discuss the literature on liquidity in bond markets. Our exposition is broken down into three parts. We begin with a review of papers that provide theories of liquidity, i.e. what underlying mechanics and economics of the markets results in illiquidity, and how these mechanics determine the premiums for liquidity. We then move on to looking at the presence of liquidity in markets that are free of default risk, i.e. the Treasury markets. Finally, we review papers that cover liquidity in credit markets, i.e. the relationship of liquidity with default risk."

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