What is a ‘Liquidity Event’?
A liquidity event is a change in the price of an underlying asset (such as equities or other fixed income securities) caused by a sudden drop in its market price. Most significant liquidity events occurred at the end of 2007, following the collapse of the subprime mortgage market. They are caused by the occurrence of two conditions. One is as follows:
A sudden change in the prices of securities such that the share price of the issuer, or other market participant, does not follow the expected trend (see below).
The issuers’ shares are so much higher than the peer group’s shares that trading in the shares does not increase the price of the share holders. It is similar to the phenomenon of a market crash where trading in a company’s shares does not increase the market value of the stock, nor can it be expected to. A sudden share price drop tends to cause a short-covering rally (see below) where the market price is so low to attract retail investors. This rally tends to continue over a period of time and, although the share price generally declines, a liquidation event is usually not anticipated.
A second condition is as follows:
A sudden drop in the share price of an issuer, or other market participant, that, by any of its market participants, exceeds the expected trend.
The amount of the immediate liquidity event is known as the expected percentage return. For example, assume that shares in a company in February 2014 had been trading at $10 (the midpoint of the market) and the share price on January 6th was the midpoint of $10,000. If there were a liquidity event as described above, the share price at the midpoint would be $12,000.
A liquidity event is the largest, most significant, and most powerful event in the stock market in the U.S. Typically, liquidity events in the U.S. tend to have an immediate, high impact.
Liquidity events are generally followed by a price rally, a market crash or a short-covering rally (see below) (source: NMLS, 2013). When an investor sells, he is effectively betting on a liquidity event (see above). After the liquidity event, the share price declines (and some times stays low).
If the liquidity event occurs soon after the event, the rally may quickly be turned into a market crash that causes large losses for the short seller.
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