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What is a good concise definition of liquidity risk?

M Willis

Active Member
Where liquidity risk is referred to, it appears to have two similar meanings:
  • the risk that an investor will be unable to buy/sell a security at its theoretical market price; and
  • the risk of experiencing cashflow problems.
The two definitions are not unrelated in many contexts (i.e. an investor may experience cashflow/liquidity problems if they hold a derivate for which a margin call is made and, if the derivative is illiquid, they may struggle to close out of the position in this eventuality).

Is it necessary to regard the term 'liquidity risk' as having two separate possible meanings, or is there a concise definition that covers both?
 
Where liquidity risk is referred to, it appears to have two similar meanings:
  • the risk that an investor will be unable to buy/sell a security at its theoretical market price; and
  • the risk of experiencing cashflow problems.
The two definitions are not unrelated in many contexts (i.e. an investor may experience cashflow/liquidity problems if they hold a derivate for which a margin call is made and, if the derivative is illiquid, they may struggle to close out of the position in this eventuality).

Is it necessary to regard the term 'liquidity risk' as having two separate possible meanings, or is there a concise definition that covers both?

This isn’t a textbook response but I think an encompassing (as opposed to concise) definition would be “the risk of not being able to convert assets to cash at the price required when needed (to pay for liabilities when they fall due).” The emphasis is on the first part (trouble selling assets) with your first definition, and the emphasis is on the second part (not being able to fund its liabilities when they fall due) with your second definition.

They are commonly distinguished as “market liquidity risk” and “funding liquidity risk” (or “cashflow liquidity risk”). As you say, they are related - but distinct - aspects of the same theme.

An example in the context of banking was published in https://www.theactuary.com/features/2017/06/2017/06/05/funding-liquidity-risk
 
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