Demystifying Volatility and Liquidity in Finance: Keys to Conscious Investing

There is no doubt that the investment world can be intimidating. Making your way into the financial universe can be an overwhelming experience if you don’t have a lot of experience or knowledge.

So, to ease the process of immersing yourself in this unfamiliar world, we will review the basics of volatility and liquidity.

Understanding what volatility and liquidity mean will allow a better view of the financial environment and will certainly allow you to make more informed decisions. This is especially key when thinking about your investment portfolio.

Volatility and liquidity are two of the most recurrent and essential concepts in the investment arena, so read on to understand what each one refers to and how they apply in the reality of the financial field.

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What is volatility?

When investing, understanding the volatility of the investment is essential to assess the level of risk associated with it.

The Royal Spanish Academy defines volatility as “price instability in financial markets”. An investment with high volatility is characterized by constant changes in prices, which translates into higher risk.

The changes, however, are not strictly negative. In fact, volatility can also go hand in hand with high returns.

Put another way, financial volatility is a concept that describes the variation in the price or return of a financial asset over a specific period.

Volatility implies the capacity of an asset to experience changes, instabilities and oscillations in its trajectory over a given period of time. If the price of an asset fluctuates significantly, it is considered highly volatile.

In the financial sphere, volatility indicates the magnitude of the variation in the profitability or price of an asset in relation to its historical average price.

Of course, this concept is crucial for risk management, as higher volatility indicates a high risk that returns will differ from expectations. Volatility is expressed as a percentage, representing how much the return of an asset can change according to its past performance.

The applicability of the concept of volatility extends to all financial products, such as stocks, funds or other equities, whose return cannot be predicted with certainty and must be evaluated by selling.

Types of financial volatility

Financial assets can exhibit different types of volatility:

• Historical Volatility: measures the fluctuation of an asset’s return over a period compared to its historical average return.
• Implied or Market Volatility: Estimates the expected volatility of an asset in the future.
• Stochastic Volatility: Refers to the uncertainty in the behavior of volatility over time.
• Deterministic Volatility: Occurs when volatility follows a stable pattern or its changes can be accurately estimated.

What is liquidity?

Asset liquidity is a crucial factor, as it represents the ability of an asset to be converted into cash in a short period of time and without experiencing a significant decline in value.

Liquidity indicates to the investor how easily and quickly he can recover his investment. A market considered highly liquid implies a greater number of transactions, thus facilitating the sale or exchange of assets.

In business, liquidity indicates a company’s ability to meet its short-term obligations, with liquid assets being those that can be converted to cash in less than one year without loss of value.

Asset types vary in liquidity, ranging from cash to real estate, and the liquidity ratio is calculated by dividing current assets by current liabilities. A ratio greater than 1 indicates an ability to pay short-term debts, while a ratio less than 1 indicates a risk of default.

It is crucial to distinguish between liquidity and solvency, as the former focuses on immediate debts, while solvency addresses long-term behavior.

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Liquidity advantages

• Payment of obligations: Liquidity enables the company to meet its regular payments in a timely manner.
• Management of unforeseen events: By having liquidity, the company has the ability to meet unforeseen expenses without compromising its financial stability.
• Investments without debt: Liquidity provides the flexibility to make investments without borrowing, which can contribute to more sustainable financial growth.
• Facilitates borrowing: When the company seeks financing through borrowing, liquidity acts as a positive indicator for the lender, as it demonstrates the company’s ability to assume its payment responsibilities.

Liquidity and Volatility in the Forex Market

The financial market, particularly the complex universe of the foreign exchange (forex) market, exhibits an intricate relationship between liquidity and volatility.

With daily volume in excess of $6.5 trillion, the forex market is positioned as a colossal financial force. However, the perception of liquidity can be misleading, so it is critical to understand the essential connection between these two concepts.

Read on to understand the relationship between volatility and liquidity and how they relate to other key aspects of the Forex market.

Factors influencing liquidity and volatility

Rollovers and times of reduced institutional participation

Rollovers, times when trades are moved to the next trading day, can influence liquidity and thus volatility. During these periods, when major financial institutions close their operations, liquidity can decrease, which can result in wider spreads and more frequent slippage.

Volatility tends to increase at these times, as the lack of institutional participation can lead to more significant price movements.

Macro Events and their Impact on Liquidity and Volatility

The release of macroeconomic reports can also significantly affect liquidity and volatility. Before and after the release of important reports, such as employment figures or interest rates, traders may withdraw their pending orders due to uncertainty about the results.

After the release, the market often experiences a surge of new orders, sometimes driven by automated algorithmic programs, which can result in a temporary increase in volatility.

Understanding volatility and liquidity is the first step on the road to investing.

The intrinsic relationship between liquidity and volatility is a fundamental consideration for traders in the financial market, and especially in the forex market.

Understanding how liquidity affects volatility and vice versa is crucial to making informed decisions and properly managing risk.

Liquidity provides the basis for efficient trade execution, while volatility offers unique opportunities and challenges.

Ultimately, traders must be prepared to adapt to variations in liquidity and volatility to successfully navigate the financial markets.

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