What does liquidity risk refer to in financial markets?

Liquidity risk refers specifically to the potential of not being able to buy or sell an asset quickly enough without causing a significant impact on its price. This type of risk is crucial for investors because, in situations where liquidity is low, they may face difficulties in exiting positions or may have to sell assets at unfavorable prices. For example, if an investor has a large volume of an asset that is not actively traded, they might struggle to find a buyer without significantly reducing the sale price.

In financial markets, liquidity risk can arise from various factors, such as market conditions, trader behavior, and the specific characteristics of the asset in question. High liquidity usually leads to better pricing and a smoother transaction process, while low liquidity can lead to increased volatility and can impact the overall financial stability of an investment portfolio.

The insight that liquidity risk provides investors is significant, as it encourages them to consider not only the inherent value of the asset but also how quickly they can convert it back into cash or move in and out of positions without incurring substantial costs.