LIQUIDITY RISK BASIC INFORMATION
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.
Showing posts with label Risk. Show all posts
Showing posts with label Risk. Show all posts
THE REAL RISK FREE RATE (RRFR) BASICS AND TUTORIALS
THE REAL RISK FREE RATE (RRFR) BASIC
What Is Real Risk Free Rate (RRFR)?
The real risk-free rate (RRFR) is the basic interest rate, assuming no inflation and no uncertainty about future flows. An investor in an inflation-free economy who knew with certainty what cash flows he or she would receive at what time would demand the RRFR on an investment.
Earlier, we called this the pure time value of money, because the only sacrifice the investor made was deferring the use of the money for a period of time. This RRFR of interest is the price charged for the exchange between current goods and future goods.
Two factors, one subjective and one objective, influence this exchange price. The subjective factor is the time preference of individuals for the consumption of income. When individuals give up $100 of consumption this year, how much consumption do they want a year from now to compensate for that sacrifice?
The strength of the human desire for current consumption influences the rate of compensation required. Time preferences vary among individuals, and the market creates a composite rate that includes the preferences of all investors.
This composite rate changes gradually over time because it is influenced by all the investors in the economy, whose changes in preferences may offset one another. The objective factor that influences the RRFR is the set of investment opportunities available in the economy.
The investment opportunities are determined in turn by the long-run real growth rate of the economy. A rapidly growing economy produces more and better opportunities to invest funds and experience positive rates of return.
A change in the economy’s long-run real growth rate causes a change in all investment opportunities and a change in the required rates of return on all investments.
Just as investors supplying capital should demand a higher rate of return when growth is higher, those looking for funds to invest should be willing and able to pay a higher rate of return to use the funds for investment because of the higher growth rate.
Thus, a positive relationship exists between the real growth rate in the economy and the RRFR.
What Is Real Risk Free Rate (RRFR)?
The real risk-free rate (RRFR) is the basic interest rate, assuming no inflation and no uncertainty about future flows. An investor in an inflation-free economy who knew with certainty what cash flows he or she would receive at what time would demand the RRFR on an investment.
Earlier, we called this the pure time value of money, because the only sacrifice the investor made was deferring the use of the money for a period of time. This RRFR of interest is the price charged for the exchange between current goods and future goods.
Two factors, one subjective and one objective, influence this exchange price. The subjective factor is the time preference of individuals for the consumption of income. When individuals give up $100 of consumption this year, how much consumption do they want a year from now to compensate for that sacrifice?
The strength of the human desire for current consumption influences the rate of compensation required. Time preferences vary among individuals, and the market creates a composite rate that includes the preferences of all investors.
This composite rate changes gradually over time because it is influenced by all the investors in the economy, whose changes in preferences may offset one another. The objective factor that influences the RRFR is the set of investment opportunities available in the economy.
The investment opportunities are determined in turn by the long-run real growth rate of the economy. A rapidly growing economy produces more and better opportunities to invest funds and experience positive rates of return.
A change in the economy’s long-run real growth rate causes a change in all investment opportunities and a change in the required rates of return on all investments.
Just as investors supplying capital should demand a higher rate of return when growth is higher, those looking for funds to invest should be willing and able to pay a higher rate of return to use the funds for investment because of the higher growth rate.
Thus, a positive relationship exists between the real growth rate in the economy and the RRFR.
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