What is liquidity risk?
Liquidity risk as an expression that describes the possibility that a business or individual trader will not be able to meet their short-term financial obligations.
Reasons for this include the fact that the business concerns is holding illiquid assets or that it is managing its cash flow inefficiently.
Where have you heard about liquidity risk?
During the 2007/8 credit crunch, the housing bubble bursting triggered bank losses which caused liquidity risk to rocket. This extreme risk was a major factor in the weakness of financial institutions and ultimately led to the bankruptcy of Lehman Brothers.
What you need to know about liquidity risk...
There are two main types of liquidity risk:
- Market liquidity risk - the possibility that when you need to trade, the market liquidity is poor, making it difficult to buy or sell
- Funding liquidity risk - the possibility that a trader has to withdraw their position(s) as a result of lack of funding
Market liquidity risk can be measured by bid-ask spread, market depth, immediacy and resilience. Fund liquidity risk can be measured by the current ratio, which divides current assets by current liabilities, or by the quick ratio, which divides the total of cash and equivalents plus marketable securities and accounts receivable by the total of current liabilities.