Liquidity risk in the financial markets represents the lack of trading volume in a particular security or asset, a situation that could make it difficult for an investor to make a transaction involving that security or asset when desired. It also refers to the speed at which a company can convert assets, including property, certificates of deposit and investments in stocks and bonds into cash. Without access to proper liquidity, investors, money managers and corporations can become cash-strapped and experience severe setbacks, especially during times of a market downturn.
One measure of liquidity risk is the spread between an asset's bid and ask price. A bid represents what buyers of an asset are willing to pay, and the ask price signifies the most recent price at which a seller was willing to unload the asset. The spread is the difference between the bid and the ask. A widening bid-ask spread represents a larger difference between buyers and sellers, which indicates reduced liquidity.
In the stock and bond markets, the risk surround liquidity is the possibility that there will be only one party, either a buyer or a seller, committed to a trade. For instance, if a trader is seeking to unload a security but no investor is interested in taking the other side of that trade, the trader runs the risk of losing profits or worse, experiencing a loss. Liquidity risk is most prevalent in thinly traded securities because there is little buying and selling activity occurring in these assets at the onset.
A stock's liquidity also determines volatility, or erratic price movements in that security. Widely traded stocks are considered a liquid investment. They can withstand large trading volumes or block trades initiated by institutional investors without demonstrating too much volatility. Thinly traded stocks, however, are a more illiquid investment. These stocks will demonstrate more volatility in the event there is an institutional-size trade in that security.
Individual investors might rely on liquidity for their livelihood. If an investor's retirement portfolio is 100 percent invested in equities, for instance, he or she will depend on selling those stocks in order to generate cash flow. The liquidity risk lies in the possibility that the financial markets will be experiencing a downturn when the time comes to sell the securities, and the investor will be left with little or no access to cash.
Fund managers, including hedge fund managers, often trade in highly complex and sometimes illiquid assets and therefore are exposed to liquidity risk. For this reason, hedge funds often require that investors agree to a lock-up period, which means that they must commit capital to a fund for a period of a year or more before requesting withdrawals. A surge of withdrawal requests can serve as a type of a "run on the bank" for a hedge fund, and if a manager is unable to liquidate assets, he might be forced to close down.