Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Liquidity Risk

What it is:

Liquidity risk is the risk that a company or bank may be unable to meet short term financial demands. This usually occurs due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process.

How it works (Example):

Liquidity risk generally arises when a business or individual with immediate cash needs, holds a valuable asset that it can not trade or sell at market value due to a lack of buyers, or due to an inefficient market where it is difficult to bring buyers and sellers together.

For example, consider a $1,000,000 home with no buyers. The home obviously has value, but due to market conditions at the time, there may be no interested buyers. In better economic times when market conditions improve and demand increases, the house may sell for well above that price. However, due to the home owner’s need of cash to meet near term financial demands, the owner may be unable to wait and have no other choice but to sell the house in an illiquid market at a significant loss. Hence, the liquidity risk of holding this asset.

Why it Matters:

Purchasers and owners of long term assets must take into account the salability of assets when considering their own short term cash needs.  Assets that are difficult to sell in an illiquid market carry a liquidity risk since they can not be easily converted to cash at a time of need.  Liquidity risk may lower the value of certain assets or businesses due to the increased potential of capital loss.

Related Terms View All
  • Auction Market
    Though most of the trading is done via computer, auction markets can also be operated via...
  • Best Execution
    Let's assume you place an order to buy 100 shares of Company XYZ stock. The current quote...
  • Book-Entry Savings Bond
    Savings bonds are bonds issued by the U.S. government at face values ranging from $50 to...
  • Break-Even Point
    The basic idea behind break-even point is to calculate the point at which revenues begin...
  • Calendar Year
    If Company XYZ starts its fiscal year on January 1 and ends its fiscal year on December...