What Is Liquidity Risk?
Liquidity risk is the uncertainty introduced by the secondary market for an investment. When an investor acquires an asset, he or she expects that the investment will mature (as with a bond) or that it will be salable to someone else.
In either case, the investor expects to be able to convert the security into cash and use the proceeds for current consumption or other investments.
The more difficult it is to make this conversion, the greater the liquidity risk. An investor must consider two questions when assessing the liquidity risk of an investment:
(1) How long will it take to convert the investment into cash?
(2) How certain is the price to be received?
Similar uncertainty faces an investor who wants to acquire an asset: How long will it take to acquire the asset? How uncertain is the price to be paid?
Uncertainty regarding how fast an investment can be bought or sold, or the existence of uncertainty about its price, increases liquidity risk. A U.S. government Treasury bill has almost no liquidity risk because it can be bought or sold in minutes at a price almost identical to the quoted price.
In contrast, examples of illiquid investments include a work of art, an antique, or a parcel of real estate in a remote area. For such investments, it may require a long time to find a buyer and the selling prices could vary substantially from expectations.
Investors will increase their required rates of return to compensate for liquidity risk. Liquidity risk can be a significant consideration when investing in foreign securities depending on the country and the liquidity of its stock and bond markets.
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