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Liquidity and flex points

Grace Concelman | Tuesday, April 10, 2012

Sitting in the Mendoza basement on a Thursday, you might hear the following conversation:

“Hey bro, I think I’m gonna invest in some liquid assets this weekend.”

“Yeah man, whatcha thinking? Natty again?”

“Nah bro, I’m gonna buy some Treasury bonds.”

Liquid assets in the financial world are those that are easy to convert to cash and can be traded without impacting their price. The most liquid asset type is cash, followed by foreign currency, government bonds and many stocks because they all trade in large, established and fairly stable markets. Assets like real estate are very illiquid because it is difficult to trade them for cash and if you want to sell quickly you usually have to significantly lower your asking price.

People value liquidity because having liquid assets means they can more easily meet immediate financial obligations.

For example, take Domer, the typical Notre Dame student. Domer has four types of assets: U.S. dollars, Domer Dollars, flex points and dining hall meals. The liquidity of these assets ranges from very liquid to very illiquid.

U.S. dollars are Domer’s most liquid assets. They can be used everywhere from Reckers to O’Rourke’s, and even beyond the Notre Dame bubble. Domer Dollars are less liquid than U.S. dollars because they are only accepted on campus. As anyone who has accidently handed their student ID card to the cashier at Chipotle knows, Domer Dollars aren’t very useful beyond the bookstore or your dorm’s laundry machines.

Flex points are slightly less liquid than Domer dollars. Since they’re meant to supplement Domer’s meal plan, flex points are only accepted at food service locations. Also, unlike Domer dollars, which can be converted to cash upon graduation, flex points have no cash value. At the end of the semester, unused flex points vanish, which explains the sudden demand for dry goods at the Huddle just as everyone is packing up to leave for the summer.

Finally, Domer’s most illiquid assets are his dining hall meals. He can’t hand his ID card to the cashier at Waddick’s and say, “I didn’t have time to go to the dining hall this morning, so I’m going to use the meal I have for today’s breakfast to pay for my coffee and bagel sandwich.” He also can’t redeem his unused meals at the end of the semester. Dining hall meals are delicious, but Domer secretly thinks they’re kind of a pain. If illiquid dining hall meals are such a pain, why does Domer bother to buy them? He could just hold dollars and pay for everything he needed on campus without having to worry about utilizing his illiquid assets.

The catch is this: The return on illiquid investments is generally higher than liquid investments because the investor is compensated for having to tie up his money.For Domer, buying a block of dining hall meals at the beginning of the semester is less expensive than if he would buy them individually with dollars or flex points. Domer chooses to forego the freedom of owning more-liquid U.S. dollars for the savings he gets by buying dining hall meals in advance. The lure of extra return on illiquid assets can sometimes lead to liquidity crises. Say Domer invests all of his money in dining hall meals. If he needs a new toothbrush from the Huddle but all of his assets are tied up in meals, he experiences a liquidity crisis where he cannot meet his financial needs with his available assets.

Liquidity is not the same as solvency. Solvency is the ability to meet financial obligations with any assets. It’s possible to be illiquid but still solvent if you have a lot of long-term assets, like if the Domer runs out of flex points but still has dining hall meals. You can’t, however, be insolvent and still liquid. If Domer also runs out of dining hall meals, he’s illiquid, insolvent and probably pretty hungry.

Grace Concelman is a senior majoring in finance and philosophy. She can be reached at [email protected]

The views expressed in this column are those of the author and not

necessarily those of The Observer.