Over my career, I have learned many lessons, but probably the most valuable one is never underestimate the importance of liquidity.
Can you sell your position? How much will it cost to do so and how long will it take? In stressed market conditions, who will make you a price? And what will happen to bid Office spreads and the size of quotes other traders are prepared to make.
At the start of the COVID crisis in March, 2020, even trading in European government bonds became very difficult.
On one occasion, I wanted to sell a three year AAA rated covered bond, and was told by my trader that the bid price was two points below where the screen suggested it was two points in price.
On a three year, highly rated bond is substantial equivalent to about 65 basis points more yield per annum.
I felt that this was an overreaction and decided to sell something else where the price was less severely affected.
All these questions become even more critical for more complex instruments.
Market crashes can kill off trading in certain instruments.
For example, after the oh 8 0 9 crisis trache and correlation trading in CDOs virtually disappeared.
It was too difficult to hedge the risk, and several banks had lost billions of US dollars.
In conclusion, you should always pay close attention to liquidity when trading or owning less liquid instruments.
Are you being sufficiently compensated for the additional risk? Will the liquidity be there when you really need it? Is your position too big? Have you diversified your risk?
