Is this a risk crisis or a liquidity crisis? What's the difference?
We can define "risk" and "liquidity" any way we like, but some definitions are more useful than others. A useful definition would explain why "risky" assets need high yields to make people willing to hold them, and why "illiquid" assets need high yields to make people willing to hold them. And useful definitions of "risk" and "liquidity" would allowed us to distinguish the two.
Here's my distinction between risk and liquidity:
The value of an asset can be decomposed into two parts: the value of the stream of dividends (where redemption counts as a final dividend) to the owner of the asset; and the value of the right (or option) to sell the asset at any time at the market price. We should use "risk" to talk about the effect of uncertainly on the value of the stream of dividends; and use "liquidity" to talk about the value of the right to sell the asset. The value of liquidity is the value of an option to sell at the market price whenever I choose to exercise that option.
This distinction between risk and liquidity seems to work. Paper money pays no dividends and is worthless to hold if we cannot sell it. Its value is 100% due to its liquidity. My toothbrush is very useful to me (it pays dividends in services not cash), but nobody would buy it, so my right to sell it is worthless. It is totally illiquid.
You can see how our understanding of "risk" has changed over time. We used to think of "risk" as the variance of return on an asset. Then we saw that variance didn't matter if it could be diversified away. Only the variance of the total portfolio mattered. The Capital Asset Pricing Model changed the definition of "risk" to the covariance of return with the market portfolio. Then we saw that the variance of return of the total portfolio only mattered if it caused variance in consumption, and the CAPM was modified to become the Consumption CAPM. The "risk" that mattered was the (negative) covariance of return with the marginal utility of consumption.
According to the CCAPM, an asset which gave its highest return in good times was the highest risk, and needed the highest expected yield to make people willing to hold it. An asset with its highest return in bad times, like when your house burned down and were most poor (and so had a high marginal utility of consumption) had negative risk. We called it house insurance. People would be willing to hold insurance even at a negative (expected) yield.
We changed our understanding of "risk" as a result of asking "why should people be willing to accept a lower yield to avoid risk?" Let's try the same route to understanding "liquidity". How should we define "liquidity" if we want to understand why people should be prepared to accept a lower yield to gain liquidity?
I started out by thinking of liquidity in terms of transactions costs. Transactions costs include things like agents' and brokers' fees, commissions, bid-ask spreads, the cost of advertising, checking the quality of the good, etc. If I buy an asset, and think I might want to sell it again in the future, those transactions costs will reduce my net capital gains (or increase my capital losses). If I expect to hold the asset for one year, then a 1% higher transactions cost will mean I will require a 1% higher yield to be willing to buy the asset. We can think of those transactions costs as the costs of a "round trip": buying the asset and selling it again immediately.
High transactions costs reduce the value of the option to sell an asset at the market price, and so reduce its liquidity.
But then I started thinking about the market for lemons. If I buy a new car, I find out by owning and driving it whether it is a lemon. But a prospective buyer cannot tell whether or not it's a lemon. That means that most used cars offered for sale will be lemons, and buyers know this, so the market price of a used car will be lower than the value of the average used car. If I buy a new car, and sell it after one year, I will face a capital loss due to the lemons problem over and above any depreciation of the fundamental value, and over and above any "round trip" transactions cost I would face in buying a used car and selling it again immediately. I should not buy a new car if I might want to sell it again soon. It is an illiquid asset.
Both transactions costs and lemons costs reduce the value of the option to sell an asset at the market price, and so reduce its liquidity.
But then I thought about the "rush to the exits" problem. Physical capital goods are like putty-clay. We can convert resources into any sort of capital goods we want (putty), but once we have built the capital goods, we cannot easily convert them back into anything else (clay). By issuing shares in a capital good, we make the capital good liquid (putty) for the individual investor, who can sell his shares to another. But it is still illiquid (clay) in aggregate; we can't all sell our shares and convert them into cash. If we try to do so, the price falls to zero.
Whether this is a problem for the individual holding the shares depends on whether his need for cash will be correlated with others' needs for cash. If the correlation is zero (and each individual is small relative to the market), the shares are perfectly liquid. If the correlation is one, the shares are perfectly illiquid. For an illiquid asset, where everyone rushes to the exit at the same time, the market price falls just when you most need the cash. We can understand illiquidity as the (negative) correlation between the marginal utility of cash and price of the asset.
That way of thinking about liquidity (or illiquidity) is sounding very similar to the CCAPM definition of risk.
So, transactions costs, lemons costs, and a negative correlation between market price and my need for cash, all reduce the value of an option to sell the asset at its market price, and so reduce its liquidity.
We are willing to pay a higher price for a more liquid asset because the option to sell that asset is worth more, even if the dividends are the same. Once you include the value of the option to sell the asset, a value that rises over time as the exercise date approaches, liquid and illiquid assets should all have the same yield.
I just wish I understood option theory better. Then I might understand liquidity better.
Worthwhile Canadian Initiative 
And if you want to say it is too speculation because they are taking a view of future price movements, I say in that case then so is every investment – so there is no such thing as speculation?
Thoughts this morning:
1. I’m beginning to think that bob may be right. I have cast my conceptual net, and I think I may have caught liquidity, or at least a lot of liquidity, but maybe I’ve caught a lot of other stuff as well. Here’s one problem with my definition: suppose there are 1-month bills and 2-month bills. But suppose there is absolutely no market in those bills (they have the original buyer’s name on them, and the government absolutely refuses to transfer the payment to anyone else). So both have zero liquidity-value under my definition, because you can’t sell them. But the 1-month bill gives you cash in 1 month, and the 2-month bill gives you cash in 2 months. So I want to say the former is closer to cash, and more liquid. But my definition says it isn’t.
2. But, bob says that as a trader he doesn’t care about fluctuations in his V(t). I don’t think that’s right. Suppose bob buys an oil share. Then he learns that gold is a great buy, so he wants to sell the oil share so he can invest in gold instead. Nothing wrong with the oil share, no bad news, same expected P(t) of oil. But bob’s personal V(t) of oil, relative to cash (which he can convert into gold shares) has just fallen below P(t), so he sells oil. Or bob faces a margin call on his oil shares, so his value (need) for cash rises. Those are cases where he cares about the liquidity of his oil shares, that I would model as a fall in bob’s V(t) for oil shares.
3. Yes, my thinking about liquidity (especially) has been influenced by reading Randy Waldmann’s posts. I really like his stuff. In some ways, this and the last liquidity post are sort of my response to his view that liquidity should not be as important as it seems to be (stating his views somewhat crudely).
4. Thanks to bob especially for his patience. My head is not as clear on this as I thought it might be. Still think I’m on to something though. Just not so sure what it is.
reason, thanks for the compliment, score one for the canadian educational system :). I have occasionally read Thoma’s blog but never commented. This is the only blog where I’ve posted comments and that only started a couple weeks ago in Nick’s return of monetarism post. I’ve enjoyed the debates over here though so I’ll certainly make a point of checking out Thoma’s blog more regularly.
“2. But, bob says that as a trader he doesn’t care about fluctuations in his V(t). I don’t think that’s right. Suppose bob buys an oil share. Then he learns that gold is a great buy, so he wants to sell the oil share so he can invest in gold instead. Nothing wrong with the oil share, no bad news, same expected P(t) of oil. But bob’s personal V(t) of oil, relative to cash (which he can convert into gold shares) has just fallen below P(t), so he sells oil. Or bob faces a margin call on his oil shares, so his value (need) for cash rises. Those are cases where he cares about the liquidity of his oil shares, that I would model as a fall in bob’s V(t) for oil shares.”
True, in a way I do have a V that is influenced by my own situation. The price I’m willing to pay for oil depends on the carry cost (storage + foregone interest) minus the usefulness of having the commodity to trade (convenience yield).
This wikipedia article shows how the convenience yield is incorporated as an adjustment to carry cost. High & increasing convenience yield gives spot commodities positive carry (which Krugman never realized)
http://en.wikipedia.org/wiki/Convenience_yield
Because my carry costs & foregone interest tend to be the same as other market actors, that’s why I say that I don’t really care about my own V(t). My own V(t) calculation for oil may show a higher convenience yield than the market, but that’s because I see the convenience yield of oil increasing for all other actors, that it is generally underpriced. If everyone else starts to think that “cash is trash” and oil is the market to be in, the convenience yield will adjust to reflect this, and then I can sell at a profit. So my ideas about carry cost, opportunity cost & convenience yield are still highly related to future P(t). I think this brings out the relationship between convenience yield and bubble-momentum-trading, the cashness of hot assets the Cochrane found..
Adam,
Don’t wander off to EV! Canada has enough brain drain as it is. I’m trying to only really comment here, as my own little “blog canadian” mercantilist campaign. I hope that some more members of the Canadian brain-drain diaspora find their way back here:)
If total inventories of oil are zero, backwardation can occur (people want to run down their inventories to negative levels, but cannot.
Is it possible that backwardation can occur even if inventories are above zero? (If so, why?) If you still have inventory, while there is bacwardation, you are foregoing profits. But maybe you think that the backwardation will be even bigger tomorrow, so you keep part of your inventory to take advantage of even bigger profits tomorrow?
If this explanation makes sense, then the “convenience yield” is really just a proxy for the possibility of even greater potential profits from having strictly positive inventory tomorrow.
In the limit, as the probability of future inventory being lower than today’s goes to zero, the size of inventory goes to zero. (If it didn’t, and you always had some unused inventory, you could make a profit by selling it, to save the carry costs.)
I’m not sure if the convenience yield concept is like the liquidity premium. Money is special, because it is the most liquid of all assets, so all other exchanges of one asset for another asset go through money, the medium of exchange. Only oil can serve as oil; only wheat can serve as wheat; but you can only trade oil for wheat via money. Dunno. It depends how far you want to push the analogy between convenience yields and liquidity yields.
I think that I have the answer. It is that you dont know how much value you are going to get out of futures. That is sort of because you dont know what your opportunity costs are going to be. So the risk of investing in futures is the scale of this uncertainy.