liquidity diversification

Liquidity diversification

Investing in a variety of maturities to reduce the price risk to which holding long bonds exposes the investor.

Ladder Strategy

An investment strategy in which one invests in several securities with different maturities. When the first one matures, the yield may or may not be used to buy another security. It is used most often with bonds and certificates of deposit. Laddering protects the investor from interest rate risk by locking in interest rates at once.

Suppose one does not use laddering: one may invest $30,000 in a five-year bond with a 4% coupon. When the bond matures, prevailing interest rates may have dropped to 2%, making it impossible to achieve the same profit reinvesting in the same type of bond. Had this investor used laddering, he/she would have put, say, $10,000 into three bonds: a five-year bond at 4%, a seven-year bond at 5.5%, and a 10-year bond at 6%. That way, if prevailing interest rates drop to 2% in five years, this only affects the reinvestment of one third of the initial $30,000 investment. This practice is also called staggering maturities or liquidity diversification.

liquidity diversification

See laddering.