What does 'liquidity' refer to in financial markets?

Liquidity in financial markets refers to the ability to buy or sell an asset quickly without significantly affecting its price. This concept is crucial because it indicates how easily an asset can be converted into cash, which is essential for investors who may need to access their funds quickly. A liquid market allows transactions to occur swiftly and with minimal price fluctuations, meaning that a buyer or seller can execute trades without incurring substantial costs due to price changes.

For example, highly liquid assets, like stocks of large companies traded on major exchanges, can be bought and sold rapidly with little price disturbance. In contrast, illiquid assets might take longer to sell or might require accepting a lower price to find a buyer quickly. Understanding liquidity is fundamental for investors, as it affects transaction costs and ultimately influences investment strategies.