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

Liquidity Function - Essay guinea pigLiquidity preference is the need to hold cash. The money in cash and the rate of beguile 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 some other than hoarded money. The high(prenominal) the liquid preference, the higher leave alone 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 lower the liquidity preference the lower will be the rate of interest that will be paid to the cash-holders.Transaction Motive This causative is related to the need of cash for the current transactions of personal and business exchanges. It is further divided into the income and business causes. The income motive is meant to bridge the interval between the receipt of income and its disbursement, and similarly, the business motive is the interval between the sentence 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 advantageous purchases. Banks keep cash in reserve to meet unforeseen needs. Individuals hold some cash to provide for illness, accident, unemployment and other unforeseen contingencies. Money under the speculative motive is for securing profit from knowing better than the market what the future will bring forth. Liquidity Vs Profitability nobble run trade-off exists between liquidity and profitability. Other things remaining constant, the more liquid a depository financial institution the lower its return on equity and return on assets (The Banker, 2004). Both asset and liability liquidity contribute to this relationship.Facts about liquidity of a ba nkThe more liquid a bank, the less economic the bankLiquid assets earn less than illiquid assets.The victimizeer the adulthood, the lower the chip in.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 composition and maturity of funds i.e. the ease with which a bank can convert assets to cash with a minimum hurt (Comptroller of the Currency Administrator of National Banks, 2001). Large holdings of cash assets evidently decrease profits because of the opportunity way out of interest income. In terms of investment portfolio, short-term securities yield lower returns compared to long-term securities. As investors appraise 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 re turns. For example, in an environment where market expectations are constant for short-term treasury 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