What is Liquidity Risk?
In respect to finance, liquidity means that how comfortably the assets (bonds, shares, plant, property, equipment, etc.) can be converted into cash. Thus, by the term ‘liquidity risk’ we can comprehend that a risk that a company or a bank may have to face when it is not able to meet its short-term financial liabilities. Most of the time it happens when the company or a bank is unable to convert a security or a hard asset (property, machinery, equipment, etc.) into cash without the loss of capital or income in the process. There are three kinds of liquidity risks: Funding Liquidity Risk, Trading Liquidity Risk, and Operational Liquidity Risk.
Get complete FRM Online Course by experts Click Here
- Funding Liquidity Risk: it is the risk that takes place when the market lacks the supply of money because of which the people/firms/industries etc, are not able to borrow. This usually occurs during a credit crunch (a sudden reduction in the availability of credit or money from banks and other lenders). So, when there’s a supply problem and we can’t borrow. This happens as a result of the world recession. Banks become risk-averse (when banks are not ready to take any risks) and they stopped lending money to the people or the organizations.
For example, if an organization needs some money to start a new operation or to buy some assets or some other such work the organization needs some kind of liquidity but couldn’t get it as the banks are being risk-averse.
This type of risk is known as Funding Liquidity Risk because there is a need for funds from another organization that is not ready to lend their funds. It is very much dependent on the environment and economic conditions prevailing at that moment and is out of our control.
- Trading Liquidity Risk: This is a risk when the market cannot hold on to the transactions. This risk is usually dealt with while dealing with cryptocurrencies, properties, etc.
It is an inability to sell the assets within a reasonable amount of time and at a required fair price. An asset is more liquid when it can be sold quickly at a fair price. The more time a particular asset takes to be sold, at a fair price and reasonable time the less liquid it turns out to be. It is also known as the Market Liquidity Risk as it occurs due to poor market conditions.
Let us understand this with an example, in an indigent economic condition, an owner of a home worth Rs. 1,000,000 will have no buyers. Therefore, the owner will not be able to sell the house at a good or fair price amount quickly and then. But when the market conditions improve and demand increases the same home may sell for more than the earlier set price. However, as the owner needed cash to meet near term financial liabilities, at that moment the owner may not be able to wait until the improvement of market conditions. So, the owner has no choice but to sell the house in that illiquid market and suffer great loss.
This reduced demand of the asset (here home) can arise due to reasons like- Highly volatile stocks that are vulnerable to fluctuation of its price, ongoing economic crisis or during the recession period, an ill reputation of the company, and the global economic scenario.
Therefore, the selling ability of the assets should be taken into consideration by the owner before purchasing the asset. The owner should check this concerning his/her own short-term cash needs. Some assets are very hard to sell in the odd market conditions and also cause a great loss to the respective owner. They carry the liquidity risk since they cannot be converted into cash at that particular time of need. Thus, leads to an increase in the potential of capital loss.
Get complete CFA Online Course by experts Click Here
- Operational Liquidity Risk: It is basically not having cash-in-hand for meeting the day to day operations. This happens when an organization is low on cash and can’t handle the operations.
For example, A person wins a lottery of millions of rupees. He quits his job and gets a new bungalow with the money. One month later, he gets all his bills (electricity, water, cable, etc). now though the person is a millionaire and lives in a big house he does not have enough cash to pay all the bills on time.
Thus, this is the Operational Liquidity Risk there is no cash to do the day to day activities on time.
After studying all the types of liquidity risks it can be said that all three of them are somewhat interrelated.
Investors should be aware of the various conditions before investing in such illiquid assets. The liquidity of the assets should be measured before any investment is done. The measurement of liquidity is done by “Bid-offer Spread”. It is the difference between the price at which an asset can be bought (i.e. Bid) and the price at which that asset can be sold (i.e. Offer). The assets such as government bonds, large-cap equities, currencies have tight bid-offer spreads and they allow the investors to invest without significant slippage. The assets like real-estate or loans have wide bid-offer spreads. So, they are less liquid. Sometimes it also happens that there is no bid for these assets (during housing crisis).
Hence, a Portfolio Manager should create a liquidity risk profile in which reserves are calculated to accommodate positions. It can be done by analyzing and studying the historical bid-offer spreads of the concerning financial instruments. This will help to create a ‘Market Risk Reserve’ where the capital can be set aside when a position is entered, and released when a position is liquidated.
Get complete FRM Online Course by experts Click Here
Author- Disha Agrawal
About the Author: Disha Agrawal is an Economics graduate and presently pursuing an MBA with a specialization in Financial Administration from the Prestige Institute of Management and Research, Indore. She is a keen learner and is intrigued by financial markets. She is committed to her work and strives for continuous improvement.