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What is Liquidity Risk?

By Bajaj Broking Team

June 13, 2025

4 mins read

Investment

Liquidity risk refers to the potential difficulty an investor or business may face when trying to convert assets into cash quickly without significantly affecting their market value. This type of risk becomes particularly evident during times of market stress, when buyers are scarce and selling an asset at its fair value becomes challenging. For investors, high liquidity risk could mean being unable to sell shares or bonds without accepting a substantial loss, especially in less active or niche markets.

This risk is not limited to individual investors—it also affects businesses and financial institutions. For example, if a company needs immediate funds to cover operational expenses but cannot liquidate its holdings in time, it might face severe financial strain. Liquidity risk can emerge from several factors, including economic downturns, regulatory changes, or the nature of the asset itself. Assets like real estate or complex financial instruments often carry higher liquidity risk compared to widely traded stocks or government bonds.

There are two primary forms of liquidity risk. Market liquidity risk arises when an asset cannot be sold quickly due to a lack of buyers. Funding liquidity risk, on the other hand, involves the inability to meet short-term financial obligations due to limited access to cash. Understanding these risks is crucial for investors to develop sound strategies that include appropriate diversification and contingency planning to navigate periods of market uncertainty.

Types of Liquidity Risk: Market vs. Funding

There are two primary types of liquidity risk: market liquidity risk and funding liquidity risk. Each type has distinct characteristics and affects different aspects of an investment or business.

Market Liquidity Risk

Market liquidity risk refers to the risk of not being able to buy or sell an asset quickly without causing a significant change in its price. This type of risk arises in markets where trading volume is low, or there are few buyers or sellers. For example, illiquid stocks or bonds might be difficult to sell at a fair price due to limited demand.

Funding Liquidity Risk

Funding liquidity risk occurs when an investor or financial institution is unable to secure the necessary funds to meet its obligations. This could be because of a shortage of capital in the market, sudden financial stress, or an inability to access credit lines. Funding liquidity risk is more commonly faced by banks or other financial institutions that rely on short-term borrowing.

Type of Liquidity Risk	Description	Example
Market Liquidity Risk	The risk of not being able to buy or sell an asset without significantly affecting its price.	Difficulty in selling a stock with low trading volume.
Funding Liquidity Risk	The risk of being unable to obtain sufficient funds to meet short-term financial obligations.	A bank unable to secure enough funds to meet customer withdrawals.

Understanding these two types of liquidity risk is critical, as they can impact different parts of an investment strategy.

Key Indicators of Liquidity Risk

Here are some key indicators of liquidity risk that investors should closely monitor to ensure the financial stability and efficiency of their portfolios:

Bid-Ask Spread:

One of the most visible indicators, a wide bid-ask spread typically signals low liquidity. When the difference between the buying price and the selling price of an asset is large, it becomes more difficult to execute trades at a fair value. This often results in higher transaction costs and potential losses for investors.
Trading Volume:

The trading volume of an asset reflects how frequently it is bought and sold in the market. A consistently low trading volume may indicate that the asset is not easily tradable, increasing liquidity risk. This makes it harder to exit or enter positions quickly without facing price disadvantages.
Market Depth:

Market depth measures the market’s ability to handle large trades without causing significant price fluctuations. If placing a relatively large order dramatically moves the price of an asset, it suggests low market depth and a higher risk of price slippage during trades.
Turnover Rate:

The turnover rate of a security or portfolio shows how actively it is traded within a specific time frame. A lower turnover rate may point to limited interest or activity in the asset, highlighting liquidity constraints.

Keeping a close eye on these indicators allows investors to detect early warning signs of liquidity risk and take proactive steps—such as diversification or rebalancing—to manage potential financial stress effectively.

Measuring Liquidity Risk: Tools & Metrics

Here is a table outlining some of the most commonly used tools and metrics for measuring liquidity risk:

Metric	Description
Current Ratio	This ratio measures a company’s ability to cover short-term liabilities with its short-term assets. The formula is: Current Assets ÷ Current Liabilities. A higher ratio indicates better liquidity, signifying that the company can easily meet its short-term obligations.
Quick Ratio	Also known as the acid-test ratio, this is similar to the current ratio but excludes inventory from assets, focusing only on more liquid assets (like cash and receivables). The formula is: (Current Assets - Inventory) ÷ Current Liabilities. It offers a more stringent view of liquidity.
Liquidity Coverage Ratio (LCR)	A regulatory requirement for banks, the LCR measures a bank’s ability to withstand short-term liquidity stress. The formula is: High-Quality Liquid Assets ÷ Total Net Cash Flows over 30 Days. A higher LCR indicates the bank is better positioned to handle liquidity disruptions.
Cash Ratio	A more conservative version of the quick ratio, the cash ratio measures a company's ability to pay off its short-term liabilities with cash or cash equivalents. The formula is: Cash and Cash Equivalents ÷ Current Liabilities. A higher cash ratio suggests greater liquidity security.

These liquidity metrics are essential for assessing both the liquidity of individual companies and financial institutions, as well as the broader market in which they operate. They help investors, analysts, and regulatory bodies gauge the ability of entities to handle liquidity stress, especially during challenging market conditions. By using these tools, investors can make informed decisions about where to allocate capital, avoid companies with poor liquidity, and ensure that their portfolios are well-positioned to manage risk.

Impact of Liquidity Risk on Investment Portfolios

Liquidity risk can have a profound impact on investment portfolios, influencing both the strategy and the performance of investments. One of the primary ways liquidity risk affects portfolios is by increasing transaction costs. In a situation where an investor needs to sell an asset quickly, they might have to accept a price lower than expected. This is due to the lack of buyers in the market, forcing the seller to reduce the price in order to attract interest. This leads to increased transaction costs, potentially eroding returns.

Another significant impact of liquidity risk is price volatility. When assets are difficult to trade, their prices can fluctuate more than anticipated, which increases the overall volatility of a portfolio. Investors may face unexpected losses if the price of an illiquid asset suddenly drops when they attempt to sell, particularly in a bear market or times of economic uncertainty.

Liquidity risk can also result in delayed execution. In highly illiquid markets, trades may take longer to execute. This delay could cause missed opportunities, as the market conditions might change while the order is being processed. Furthermore, if the investor is unable to sell an asset at the desired price due to low liquidity, they might not be able to exit a position at an optimal point, potentially leading to losses.

Additionally, liquidity risk can limit diversification in an investment portfolio. In certain cases, illiquid assets might make it challenging to rebalance the portfolio or adjust positions. During market stress, when there is a higher likelihood of needing to liquidate positions quickly, the inability to sell certain assets can become a major hindrance to portfolio management.

Given these impacts, managing liquidity risk is crucial for maintaining a well-balanced and resilient portfolio. Failing to account for liquidity risk can leave investors vulnerable to substantial losses, particularly when markets are volatile or during periods of economic distress. Proper assessment and planning for liquidity risk can help investors avoid these pitfalls and make more informed decisions regarding their investments.

Strategies to Manage and Mitigate Liquidity Risk

Several strategies can be implemented to manage and mitigate liquidity risk:

Diversification:

Spreading investments across different asset classes, sectors, and markets can help reduce the impact of liquidity risk. By holding a mix of liquid and illiquid assets, investors can balance potential returns and risk exposure.
Liquidity Buffers:

Maintaining a portion of a portfolio in highly liquid assets, such as cash or government bonds, can provide a buffer against liquidity risk during market disruptions.
Staggered Maturities:

For fixed-income investments, staggered maturities minimize the risk of liquidity issues. This provides for more stable cash flows and averts investment concentration during less liquid times.

Constant Monitoring:

Monitoring liquidity indicators and market conditions enables investors to see potential risks on time. Continuously evaluating the liquidity of assets and market tendencies allows for more efficient risk handling.

By using these strategies, investors can reduce their exposure to liquidity risk and ensure that their portfolios remain well-positioned even in volatile market conditions.

Liquidity Risk in Indian Financial Markets

Liquidity risk in Indian financial markets is a major issue, more so because of the fast-changing market structure in the country and the growing participation of foreign investors. With the growth of the Indian stock market, some shares, particularly in the mid and small-cap space, may experience periods of low liquidity. These stocks often experience wider bid-ask spreads, meaning the difference between the buying and selling price is greater, which can make it harder for investors to enter or exit positions without impacting the price. This condition leads to higher liquidity risk, as investors might not be able to sell their holdings at desired prices, particularly during periods of high volatility.

The expansion of financial products like exchange-traded funds (ETFs), mutual funds, and derivatives in India has increased the complexity of liquidity risk. Although these products provide more hedging opportunities, trading opportunities, and diversification opportunities, they can also bring new liquidity issues. For instance, when there is market stress or increased volatility, the liquidity in such products can evaporate, making investors unable to close positions without substantial losses.

To mitigate liquidity risk in the Indian markets, investors need to keep a close eye on liquidity indicators such as bid-ask spreads, trading volumes, and market depth. Diversifying across various sectors and asset classes can also help spread risk and reduce the impact of liquidity problems in any one area. Additionally, maintaining flexibility within investment portfolios allows investors to adapt quickly to changing market conditions, ensuring they can respond effectively when liquidity issues arise. Proper management of liquidity risk is essential for navigating the complexities of Indian financial markets.

Conclusion

Finally, liquidity risk is an important consideration in the investor decision-making process. Regardless of whether stocks, bonds, or other asset classes are involved, recognizing and effectively managing liquidity risk is vital to protecting portfolios and maintaining stability amidst market volatility. If liquidity risk is not taken into consideration, investors will encounter difficulties such as higher transaction costs, lost opportunities, or inability to make trades at beneficial prices. By applying sound liquidity measures such as bid-ask spreads, trading volume, and market depth, investors can spot and track possible risks.

Furthermore, the use of sound strategies like diversifying investment across different sectors or asset classes and keeping the portfolio flexible can assist in managing liquidity risk. Knowledge of overall market conditions, such as times of economic instability or market tension, is also important in foreseeing possible liquidity issues. Investors can minimize exposure to liquidity risk, improve decision-making, and navigate volatile markets more effectively with the proper tools and information. Ultimately, liquidity risk management is an integral part of having a well-balanced investment portfolio that can handle both peaceful and turbulent market situations.

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