What does liquidity risk refer to?

Liquidity risk refers specifically to the risk of being unable to efficiently buy or sell assets without causing a significant impact on the asset's price. This can occur when a market lacks sufficient depth or participants, making it challenging for an investor to execute transactions quickly. In essence, liquidity risk highlights the possibility that an asset cannot be readily converted into cash at its fair market value, particularly in situations where quick access to cash is needed.

For example, during times of financial distress or market stress, certain assets may become illiquid. An investor holding such assets may find it very difficult to sell them without taking a substantial haircut on their value, or they may be unable to sell them at all if there are no buyers. Understanding liquidity risk is crucial for risk managers as it can pose significant challenges to maintaining a portfolio's desired risk-return profile and operational routine.