What does liquidity risk signify?

Liquidity risk signifies the potential difficulty of selling an asset without incurring a loss. This risk arises when there are not enough market participants willing to buy the asset, or when the market for that asset is limited, which may force the seller to lower the price to make a sale. In essence, liquidity risk reflects the possibility that an investor may not be able to exit a position or convert their investment into cash quickly or without a significant decrease in value.

Understanding liquidity risk is crucial for investors and companies alike, as it can heavily impact their financial health and investment strategy. For example, assets that are illiquid often require a longer time frame to sell, and in a downturn, they may be worth significantly less if a quick sale is necessary. Hence, it's vital to manage liquidity risk to ensure that there are sufficient liquid assets available to meet obligations when they arise.