What does liquidity risk refer to in finance?

What does liquidity risk refer to in finance?

• A. The risk of losing money in investments
• B. The risk that assets cannot be sold quickly to avoid a loss
• C. The risk associated with interest rate fluctuations
• D. The risk of inflation affecting asset value

Answer: (B)

Liquidity risk in finance refers to the possibility that an individual or firm will not be able to sell an asset quickly enough to prevent a loss or to meet financial obligations. This concept is crucial because it highlights the potential difficulties in converting an asset into cash without significantly affecting its market price. For example, if an entity holds an investment in a stock that is not traded frequently, it may find itself in a situation where, despite the stock having intrinsic value, it cannot be sold promptly or at an acceptable price during a time of need. This scenario emphasizes the importance of having a liquid market for assets, where buyers and sellers can enter and exit their positions easily. This understanding distinguishes liquidity risk from other financial risks, such as market risk related to investment losses or interest rate risk, which pertains to the variability in returns that can arise from changes in interest rates. Additionally, inflation risk concerns the erosion of purchasing power over time, which is separate from the ability to quickly convert assets into cash. Therefore, the definition relating to the inability to sell assets quickly to avoid losses captures the essence of liquidity risk effectively.

Liquidity risk in finance refers to the possibility that an individual or firm will not be able to sell an asset quickly enough to prevent a loss or to meet financial obligations. This concept is crucial because it highlights the potential difficulties in converting an asset into cash without significantly affecting its market price.

For example, if an entity holds an investment in a stock that is not traded frequently, it may find itself in a situation where, despite the stock having intrinsic value, it cannot be sold promptly or at an acceptable price during a time of need. This scenario emphasizes the importance of having a liquid market for assets, where buyers and sellers can enter and exit their positions easily.

This understanding distinguishes liquidity risk from other financial risks, such as market risk related to investment losses or interest rate risk, which pertains to the variability in returns that can arise from changes in interest rates. Additionally, inflation risk concerns the erosion of purchasing power over time, which is separate from the ability to quickly convert assets into cash. Therefore, the definition relating to the inability to sell assets quickly to avoid losses captures the essence of liquidity risk effectively.