Liquidity risk is a term in finance. In essence, it is the risk
that an asset you might want to trade in the future can no longer be
traded, or can no longer be traded without excessive cost - in other words,
the risk it is no longer liquid. Okay, so, we have a nice
dictionary definition. But what does this mean?
This whole definition revolves around the word "liquid". Liquid means
"easy to convert to cash", and usually also the other way around. Imagine I
have a market, in which there is a bid for 10.000 shares at 20.51
dollars. Want to sell more? Fine, there is another bid for 30.000 shares at
20.50 dollars. Hence, I can sell 40.000 shares for an average price of
20.5025 dollars. Imagine the ask price is at 20.52 for 20.000 shares, and
20.53 for another 20.000. This means I can buy 40.000 shares for an average
price of 20.525. Hence, I can buy and sell a little over 800,000 worth
of shares for a total cost of 900. which is not excessive. In other words,
if for some reason I have to sell a position I just bought a moment ago,
this will cost me around 0.1% of the value of the position, which is not a
Liquidity risk is the risk that this situation changes-for the worse.
Imagine I bought these 40.000 shares, and the whole market crashes. Now, in
this case, the market might be 17.05 bid and 17.09 ask-but only for 1000
shares. To do my 40.000 shares, I will need hit several bids. Imagine that
there is 1000 more at 17.03, 1000 more at 17.01, all the way down. In this
case, even though the theoretical price of the stock is 17.07, I will
actually only sell on average for something like 16.64-another 2.5% loss!
And, imagine I had even more shares, like 80.000-the position might be too
large to unwind.
To give you another example: Many exchanges temporarily close for
instantaneous trading if they drop too much, or suspend trading in a stock
if it drops too rapidly. This in essence means you are stuck, cannot cut
your losses, and cannot control your risk.
As unpleasant as this sounds, this is actually a rather benign form of
liquidity risk. For common stocks, bonds, and
options, the market will open again, and you will be able to cut
your losses. Now, imagine you are trading some special product, like an
option on a bond issued by a third-world country or whatever.
Presently, there are a few parties trading these bonds. Now, imagine a
famine strikes your third-world country. No one knows what the bond is
worth, let alone the option. So, no one will be willing to buy it from
you at any reasonable price: you are pretty much stuck with it. You can't
hedge, can't get out, and are left with a huge, uncoverable risk - or maybe,
your boss is, as you will likely be fired.
Now, to add insult to injury, liquidity tends to dry up when you need it
most. In other words, when panic ensues, everyone wants to get out through
the same small hole. We all know what happens when we try to
force too many people through a small hole. This makes liquidity risk a
very serious risk, especially if you are a big firm.
In case you were wondering, yes, liquidity risk is one of the things
that allowed the whole subprime crisis to become as bad as it got. Banks
had large positions in subprime bonds or derivatives based
on subprime bonds. When the crisis hit, suddenly no one
knew that the bonds were worth, and there were few people wanting to trade
them. This not only meant that there was no good way of determining the
value of these bonds, and hence, no way to know how badly the banks were
hurt. It also meant the banks could not unwind their position to get
capital back - they were pretty much stuck and had to ask for a government
In summary, liquidity risk is the risk that it is not possible to trade
a significant volume in a product when you need to so. This is a pretty
serious risk, as it usually happens when you badly need to trade. The
problem is typically larger for a large firm than for a private investor, as
private investors rarely need to unwind a large position.