What impact does liquidity have on an asset's price?

The chosen answer highlights the relationship between liquidity and price volatility. Low liquidity implies that there are fewer buyers and sellers in the market for a particular asset, which can lead to significant price fluctuations. When trades are executed in an illiquid market, even small trades can lead to large changes in the asset's price because there are not enough participants to absorb those trades without affecting the market price significantly.

For example, if an investor wishes to sell a large quantity of assets in a low liquidity environment, this could lead to a sharp drop in price as the available buyers at or near the market price may not be able to accommodate the volume, driving the price down further. Conversely, when liquidity is high, large transactions can occur with minimal impact on price, leading to more stable price movements.

Understanding the dynamics of liquidity helps investors gauge the risk of price volatility in their asset investments and make more informed trading decisions. This emphasizes why liquidity plays a vital role in determining price behaviors in financial markets.