What does 'liquidity risk' refer to?

Liquidity risk is best described as the risk that an asset cannot be traded quickly enough to prevent a loss. This concept is critical in finance and investment, as it highlights the problems that can arise when an investor tries to sell an asset but cannot do so quickly enough, either because there is not enough market activity or because the market for that specific asset has become illiquid.

When a market lacks liquidity, it may lead to situations where selling an asset would require the seller to accept a price significantly below the market value, resulting in financial losses. For example, during times of economic stress or uncertainty, certain assets may become difficult to sell, especially if there is a sudden influx of sellers trying to exit their positions simultaneously.

In this context, liquidity risk emphasizes the importance of understanding not just the value of an asset, but also the conditions under which it can be sold. Investors must be aware that even seemingly solid investments can pose risks if they become too difficult to liquidate quickly without incurring losses.