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0 Liquidity
Liquidity describes the degree to which an asset or security can be quickly bought or sold in
the market without affecting the assets price. An asset that can be converted into cash
immediately are said to be have high liquidity and asset that cannot be converted into cash
immediately are considered low liquidity. The more liquid an asset is, the more desirable it is
(holding everything else constant) (Mishkin, 2009). Generally, liquidity is defined as the
ability of a firm to meet its debt obligations without incurring unacceptably large losses.
For example, if a person wanted to buy a refrigerator worth RM1000 but has no
cash, he probably have a painting collection worth RM1000, he unlikely hard to find
someone that willing to trade the painting collection for a refrigerator. Instead he needs to
sell the collection and use the cash to purchase the refrigerator he might happen to take a
long time to sell the collection and if he need sell, he might sell the collection at discount
which the painting collection can be said as the illiquid asset because it cannot converted
into cash as immediate as the assets owner wanted and cannot sustained its value.
Investors are care about liquidity; they are willing to accept a lower interest rate on
more liquid investment than on less liquid illiquid investment, all other things being equal.
Hence a less liquid asset must pay a higher yield to compensate savers for their sacrifice of
liquidity. (Hubbard, 2005)
Figure 1
The difference between Pliq1 Pilliq1 is the premium that the investor received as they willing to
take position on the less liquid market.
2.0 Taxation
2
Taxation refers to the act of a taxing authority actually levying tax. The tax levied by a
government on a product, income or activity were to finance government expenditure. One
of the most important uses of taxes is to finance public goods and services such as street
lighting and cleaning. Tax can be indirect tax and direct tax.
Figure 2
If nothing else changes, a decrease in a bonds tax liability raises it prices and decreases its
yield.
a. If municipal bonds become tax exempt, lenders decrease their holdings of
taxable US government bonds, and the demand curve shifts to the left, from
Bdtax0 to Bdtax1 in (b), reducing the price of taxable bonds.
b. Lenders increase their demand for tax-exempt bonds, so that the demand curve
shifts from Bdtax-ex0 to Bdtax-ex1 in (a), raising the price of tax-exempt bonds.
c. The difference in the bond prices is matched by a difference in the required
returns. The gap between itax1 and itax-ex1 is the tax component of the difference in
yields.
REFERENCES
Hubbard, R. G. (2005). Money, the Financial System, and the Economy, 5th Edition, United
States: Pearson Addison-Wesley.
Income Tax Treatment, Retrieved from:
http://www.investopedia.com/exam-guide/cfp/income-respect-decedent/cfp3.asp
Mishkin, Frederic S. (2009). The Economics of Money, Banking & Financial Market, 10th
Edition, New York: Pearson Addison-Wesley
What is Liquidity Risk? , Retrieved from:
http://www.frbsf.org/economic-research/publications/economicletter/2008/october/liquidity-risk/