What is Liquidity Risk?
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 Does Liquidity Risk Work?
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 Does Liquidity Risk Matter?
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.
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