Liquidity Function Essay Example | Topics and Well Written Essays - 1500 words

Liquidity Function - Essay ExampleLiquidity preference is the desire to discombobulate cash. The money in cash and the commit of interest which is demanded in exchange for it is a measure of the degree of our disquietude (ICFAI Center for Management Research (ICMR), 2005). The rate of interest, in Keynes words, is the premium which has to be offered to induce people to hold the wealth in some form other than hoarded money. The higher the fluidness preference, the higher go forth be the rate of interest that will have to be paid to the holders of cash to induce them to part with their liquid assets. The let down the liquidity preference the lower will be the rate of interest that will be paid to the cash-holders.Transaction Motive This motive is related to the need of cash for the current legal proceeding of personal and business exchanges. It is further divided into the income and business motives. The income motive is meant to bridge the interval amidst the receipt of income and its disbursement, and similarly, the business motive is the interval between the time of incurring business costs and that of the receipt of the sale proceeds.Precautionary Motive The precautionary motive relates to the the desire to provide for contingencies regarding sudden expenditures and for unforeseen opportunities of expedient purchases. Banks keep cash in reserve to meet unexpected needs. Individuals hold some cash to provide for illness, accident, unemployment and other unforeseen contingencies. Money under the risky motive is for securing profit from knowing better than the market what the future will bring forth. Liquidity Vs ProfitabilityShort run trade-off exists between liquidity and profitability. Other things remaining constant, the more liquid a bank the lower its return on equity and return on assets (The Banker, 2004). Both asset and obligation liquidity contribute to this relationship.Facts about liquidity of a bankThe more liquid a bank, the less(prenomin al) profitable the bankLiquid assets earn less than illiquid assets.The shorter the maturity, the lower the yield.The highest yielding loans are loans with the highest default or interest rate risk and are therefore the least liquid. Asset liquidity is influenced by the musical theme and maturity of funds i.e. the ease with which a bank can convert assets to cash with a minimum loss (Comptroller of the Currency Administrator of National Banks, 2001). declamatory propertys of cash assets evidently decrease profits because of the opportunity loss of interest income. In terms of investment portfolio, short-term securities yield lower returns compared to long-term securities. As investors value price stability and therefore long-term securities pay a yield premium over short term securities, to induce the investors to extend their holding period. For banks that purchase short-term securities, this increases the liquidity but at higher potential returns. For example, in an environment where market expectations are constant for short-term exchequer yields, the treasury yield curve will slope upwards, reflecting liquidity premiums that increase with maturity. A banks loan portfolio displays the same trade-off where the loans carrying the higher yields are the least