What is liquidity risk?

Liquidity risk has different meanings in different contexts. In investing terms, bondholders face varying liquidity risks based on the likelihood that they may have to sell a bond below its listed value. This type of liquidity risk can actually extend to any security, describing the risk that an asset finds no buyers due to lack of liquidity in its given market. In economics and business management, liquidity refers to the ability of a financial institution to meet its operational and debt obligations without incurring severe losses or defaulting.

These two types of risk are sometimes called funding (cash-flow) liquidity risk and market (asset) liquidity risk.

Liquidity Risk in Investing

Within the commonly accepted categories of financial risks, liquidity risk is considered a type of market risk. It describes the phenomenon of opposing market participants (buyers and sellers) that are unable to find one another in a timely manner. Since no trade can be made, buyers may have to raise their bids or sellers may have to lower their asks to exchange an asset.

Different assets are often categorized into different levels of liquidity risk, and investors generally demand more returns for increased liquidity risk. All tradable assets assume some level of liquidity risk. This is even true in highly liquid markets, such as the foreign exchange, where liquidity fluctuates based on which markets are currently open.

Liquidity Risk in Economics

A primary concern among accountants and treasurers, business liquidity risk asks how well-positioned a company is to pay its bills if revenues slow down. This type of risk is very closely related to credit risk, leverage and cash flow. Companies that have higher liquidity risks are more likely to face default and receive poor credit ratings.

Source : Investopedia