What does liquidity risk refer to?

Liquidity risk specifically refers to the possibility that an asset cannot be sold quickly without incurring a significant loss in its value. This situation can arise in various markets, particularly when there are few buyers available or when the asset's market conditions are unfavorable.

For instance, if an investor holds a security or an asset that has low trading volume, they may find it difficult to sell at a desired price, leading to a situation where they have to accept a much lower bid than expected. This is especially pertinent in times of market stress, where the ability to quickly convert assets into cash is critical.

Understanding liquidity risk is essential for traders and investors because it directly impacts their ability to execute trades effectively and manage their portfolios. Effective risk management strategies involve monitoring the liquidity profile of assets and preparing for scenarios where selling could lead to losses.