In the simplest terms, liquidity risk refers to the likelihood that an investment won’t have an active buyer or seller when you are ready to buy or sell it. Therefore, you will be stuck holding the investment at a time when you need cash and can cause you to take massive losses.
Liquidity poses a significant threat to investors’ financial well-being, therefore we wanted to discuss what liquidity risk is.
One of the reasons for the losses suffered by financial firms during the Great Recession was the fact that these companies owned illiquid securities. When they found themselves without enough cash to pay the day-to-day bills, they went to sell these assets but discovered that the market had dried up completely.
As a result, they had to sell at any price they could get.
On the upside, there is an opportunity with liquidity risk because other companies and investors that were flush with cash were able to buy distressed assets. Some of these “vulture” investors made a killing because they had balance sheets that could support holding non-liquid investments for long periods of time.
To compensate for liquidity risks, investors often demand a higher rate of return on money invested in illiquid assets, especially private placement deals.
Types of Liquidity Risks:
Bid/Offer Spread Widening
When an emergency hits the market or an individual investment, you may see the bid (buyer) and ask(seller) spread wider apart so that the market has a difficult time matching up buyers and sellers.
Example, you own Main Event Entertainment [JSE: MEEG] shares, you need the cash and ask for J$6.00, but the highest bid is J$ 5.00, you will have difficulty gettings funds as you either take the loss and sell at J$5.00 or wait and hope it goes to J$6.00 in the time frame you want!
Inability to Meet Cash Obligations When Payment Is Due
Puerto Rico bonds holders, you know what we are talking about here. This is the investment equivalent of defaulting on a debt. If a company has $100 million in bonds that reach maturity, it is expected to pay off the entire $100 million balance by the maturity date.
Most of the time, businesses refinance this debt. But what happens if the debt markets aren’t working and are unable to borrow money? In that case, if the company couldn’t come up with the whole $100 million, it could be hauled into bankruptcy court even if it is highly profitable. You would find yourself locked into what could be years of legal workouts due to the firm mismanaging its liquidity risk.
Inability to Meet Funding Needs at an Affordable Price
This is when it is impossible for a company or other investment to raise enough money to function correctly and meet its needs at a price that is economical. Wal-Mart Stores, Inc., for example, is one of the biggest and most profitable companies on the planet. It has tens of billions of dollars in debt to optimise the company’s capitalisation structure.
If the markets went haywire tomorrow and Wal-Mart could no longer borrow at 6% and investors instead demanded 30%, it would make no sense for the company to issue bonds. In effect, the market’s liquidity would have dried up entirely and the stockholders of Wal-Mart would have to worry about the company coming up with enough cash to wipe out all of its debt.
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