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The meaning of liquidity risk and how to manage it when investing
You've heard of major institutions grappling with liquidity risk, but what does that mean for the average investor?
Here, we break down liquidity risk, contrast it with credit risk and reveal insights and strategies that every investor should know.
Here, we break down liquidity risk, contrast it with credit risk and reveal insights and strategies that every investor should know.
QUOTE
"Liquidity is like oxygen. When it's present, nobody really notices. But when it's absent, everybody notices."
Big ideas
- Liquidity risk significantly influenced the 2008 financial crisis, where a lack of liquidity led to the downfall of major financial institutions and global economic challenges.
- The liquidity risk premium, an often-overlooked factor, plays a critical role in investment decisions, affecting the true cost and potential return of less liquid assets.
- Liquidity risk stress testing is a key tool used by financial professionals to assess how assets might perform in extreme market conditions, helping to build more resilient investment strategies.
Introduction to liquidity risk
Liquidity refers to how quickly and easily an asset can be converted into cash without affecting its market price.
The more readily an asset can be sold at a fair price, the higher its liquidity. Cash is highly liquid, while assets like real estate are less so due to the time it may take to find a willing buyer.
The more readily an asset can be sold at a fair price, the higher its liquidity. Cash is highly liquid, while assets like real estate are less so due to the time it may take to find a willing buyer.
What is liquidity risk?
DEFINITION
Liquidity risk involves the uncertainty of not being able to swiftly convert an asset into cash, especially during financial downturns when market liquidity often decreases, leading to situations of 'no liquidity'.
This risk is crucial for investors to understand, as it affects the balance between the desire for readily accessible assets and the potential higher returns from less liquid investments.
Understanding liquidity risk and its significance
Liquidity risk really only becomes relevant in situations where selling the asset quickly is necessary. When an investor has enough time to convert an asset into cash, then liquidity is less of an issue.
Banks and other financial institutions are faced with the same type of liquidity risk as individual investors, though it can be more severe sometimes. Liquidity is needed by banks to meet sudden large withdrawals initiated by customers.
However, these banks may be unable to satisfy this requirement due to a substantial percentage of their assets being tied down for long-term lending or investment purposes, which cannot be quickly converted into cash without suffering losses in the process.
The lack of compatibility between assets that can easily turn into cash and demand for cash often results in a liquidity crunch hence affecting the ability of banks to fulfil withdrawal requests.
Banks and other financial institutions are faced with the same type of liquidity risk as individual investors, though it can be more severe sometimes. Liquidity is needed by banks to meet sudden large withdrawals initiated by customers.
However, these banks may be unable to satisfy this requirement due to a substantial percentage of their assets being tied down for long-term lending or investment purposes, which cannot be quickly converted into cash without suffering losses in the process.
The lack of compatibility between assets that can easily turn into cash and demand for cash often results in a liquidity crunch hence affecting the ability of banks to fulfil withdrawal requests.
Liquidity events behind financial crisis
An individual investor should understand that such institutions’ liquidity risks can have broader consequences on financial markets, possibly affecting their own investments’ liquidity and value.
Arguably, many financial crises start as a result of some kind of a “liquidity event”.
Frequently, a crisis starts when some players in the market experience some severe shortage of liquidity, thereby causing confidence to erode so fast that it leads to a chain reaction throughout the whole economy.
When there isn't enough liquidity within institutions or markets, this could translate into widespread sell-offs, credit squeezes, or even bank failures.
Arguably, many financial crises start as a result of some kind of a “liquidity event”.
Frequently, a crisis starts when some players in the market experience some severe shortage of liquidity, thereby causing confidence to erode so fast that it leads to a chain reaction throughout the whole economy.
When there isn't enough liquidity within institutions or markets, this could translate into widespread sell-offs, credit squeezes, or even bank failures.
Real-world examples of liquidity risk
Liquidity risk has had notable impacts in the financial world, with two significant instances: the collapse of Lehman Brothers in 2008 and the crisis at Silicon Valley Bank in 2023.
Example
The collapse of Lehman Brothers in 2008 provides a perfect illustration of liquidity risk on a catastrophic scale. This famous investment bank had heavily invested in mortgage-backed securities, which became illiquid following the collapse of the housing market. During that time, Lehman Brothers was attempting desperately to sell these assets off in order to meet its obligations, but unfortunately, it failed and ended up bankrupting itself.
Example
In 2023, Silicon Valley Bank experienced its own problems related to a lack of liquidity. Due to being oriented towards technology firms and startups, this bank had a great part of its assets locked up in long-term investments. The bank could not sell its assets quickly enough when private equity investment dried up in tech, and tech companies started to withdraw their funds, thus leading to a liquidity crunch when many of these firms withdrew their deposits at once.
Example
Consider, for instance, the case of an investor who is faced with an unexpected life event, such as divorce, necessitating the quick sales of assets.
However, if this investor’s portfolio consists mainly of illiquid investments like specialised real estate or niche market stocks it will make it difficult for them to sell without suffering some losses. If there is an immediate need to cash out, the investor may have to accept a much lower price than they had anticipated, and that has a direct impact on his or her financial well-being.
However, if this investor’s portfolio consists mainly of illiquid investments like specialised real estate or niche market stocks it will make it difficult for them to sell without suffering some losses. If there is an immediate need to cash out, the investor may have to accept a much lower price than they had anticipated, and that has a direct impact on his or her financial well-being.
These examples – from major financial institutions down to individual investors highlight how crucial it is for one to know and manage liquidity risk. It demonstrates that irrespective of size, illiquid assets can present significant difficulties during times of financial stress.
Measuring liquidity risk: Key ratios and formulas
1. Market liquidity risk
Effectively assessing market liquidity risk entails analysis of three key dimensions, which are depth, width and resilience.
- Depth represents the volume of securities traded and the effect of trade orders on market prices.
In a “deep” market, there are a lot of shares being traded, so big orders will not affect the market price very much. Conversely, in a “shallow” market, fewer shares are traded; therefore, large orders can have a great influence on the market prices. - Width refers to the bid-ask spread, which is the difference between an asset’s selling and buying prices.
A “wide” spread means that sellers want something different from what buyers are willing to pay for it, making transaction completion difficult. A “narrow” spread shows little difference between the two parties, facilitating easier transaction completions. - Resilience hinges upon how fast pricing stabilises in the instance of an above-averagely large trade.
Market resilience is said to be high when prices quickly revert to their previous levels following significant transactions.
2. Funding liquidity risk
One of the primary tools used in this assessment is liquidity risk ratios. These ratios provide a quantitative measure of how easily an asset or a company can meet its short-term financial obligations without incurring losses.
A commonly used metric is the Current Ratio, which compares a company's current assets to its current liabilities. This ratio gives an indication of the company's ability to pay off its short-term debts with its short-term assets. A higher current ratio suggests better liquidity, meaning the company is more likely to manage its debts effectively in the short term.
Another important measure is the Quick Ratio, also known as the Acid-Test Ratio. This ratio is similar to the Current Ratio but provides a more stringent measure by excluding inventory from current assets. Since inventory is not always easily convertible to cash, the Quick Ratio offers a robust view of a company's ability to meet short-term liabilities with its most liquid assets.
Liquidity risk can also be evaluated using the Cash Ratio, which is even more conservative. It measures the amount of cash and cash equivalents a company has against its current liabilities. This ratio indicates the company's ability to pay off its short-term liabilities immediately with cash or assets that are quickly convertible to cash.
A commonly used metric is the Current Ratio, which compares a company's current assets to its current liabilities. This ratio gives an indication of the company's ability to pay off its short-term debts with its short-term assets. A higher current ratio suggests better liquidity, meaning the company is more likely to manage its debts effectively in the short term.
Another important measure is the Quick Ratio, also known as the Acid-Test Ratio. This ratio is similar to the Current Ratio but provides a more stringent measure by excluding inventory from current assets. Since inventory is not always easily convertible to cash, the Quick Ratio offers a robust view of a company's ability to meet short-term liabilities with its most liquid assets.
Liquidity risk can also be evaluated using the Cash Ratio, which is even more conservative. It measures the amount of cash and cash equivalents a company has against its current liabilities. This ratio indicates the company's ability to pay off its short-term liabilities immediately with cash or assets that are quickly convertible to cash.
3. Liquidity risk in investing
In the context of personal investing, liquidity risk assessment might involve analysing the liquidity of individual investments. For instance, an investor might look at the trading volume of a stock to gauge its liquidity. A higher trading volume generally indicates higher liquidity, implying that the stock can be sold more easily without a significant impact on its price.
Liquidity risk vs credit risk: Distinguishing the differences
Liquidity risk is about how easily an asset can be sold, while credit risk centres on whether the borrower will be able to repay and if he/she will default.
Both risks can affect an investment’s value, but they operate in different fields. An asset may exhibit high levels of liquidity but at the same time pose high credit risk and vice versa.
Both risks can affect an investment’s value, but they operate in different fields. An asset may exhibit high levels of liquidity but at the same time pose high credit risk and vice versa.
Strategies for managing liquidity risk
Improving personal investment liquidity: General tips
One fundamental approach is diversification. By spreading investments across various asset classes with differing liquidity levels, investors can reduce the overall liquidity risk in their portfolios.
For example, mixing highly liquid assets like certain stocks or government bonds with less liquid assets such as real estate or collectables can balance the liquidity profile.
Another strategy is maintaining an emergency cash reserve. Having a portion of the portfolio in highly liquid assets, like cash or money market funds, ensures that there are readily available funds in case of an immediate need, reducing the pressure to sell less liquid assets at a loss.
Regularly reviewing and adjusting the portfolio is also key. Market conditions and personal financial situations change, and what may have been a suitable liquidity risk level at one time might not be appropriate later.
For those using Trading 212 Pies it is easy to rebalance the asset allocation by increasing or decreasing the percentages allocated to slice of the pie. Megacap stocks like Apple (AAPL) and Microsoft (MSFT) have higher liquidity than lesser known stocks or ETFs.
For example, mixing highly liquid assets like certain stocks or government bonds with less liquid assets such as real estate or collectables can balance the liquidity profile.
Another strategy is maintaining an emergency cash reserve. Having a portion of the portfolio in highly liquid assets, like cash or money market funds, ensures that there are readily available funds in case of an immediate need, reducing the pressure to sell less liquid assets at a loss.
Regularly reviewing and adjusting the portfolio is also key. Market conditions and personal financial situations change, and what may have been a suitable liquidity risk level at one time might not be appropriate later.
For those using Trading 212 Pies it is easy to rebalance the asset allocation by increasing or decreasing the percentages allocated to slice of the pie. Megacap stocks like Apple (AAPL) and Microsoft (MSFT) have higher liquidity than lesser known stocks or ETFs.
Liquidity strategies for investment decision-making
Understanding the liquidity risk premium and incorporating it into investment decisions can be beneficial.
DEFINITION
Liquidity risk premium is a concept in finance that refers to the extra return that investors demand for holding an asset that is relatively less liquid.
In simpler terms, it's the additional compensation investors expect for the risk of not being able to quickly sell the asset without a significant loss in value.
In simpler terms, it's the additional compensation investors expect for the risk of not being able to quickly sell the asset without a significant loss in value.
Acknowledging that investments with higher liquidity risk might offer higher returns as compensation helps in making more informed choices about risk-reward trade-offs.
Additionally, it’s important to remember that these strategies are not about eliminating risk but managing it effectively.
Additionally, it’s important to remember that these strategies are not about eliminating risk but managing it effectively.
Liquidity risk in different investment vehicles
Asset | Liquidity risk | Description |
Stocks (major exchanges) | Low | Highly-traded, easy to buy/sell, low impact on price. |
Small-cap stocks | High | Lower trading volumes, harder to sell without impacting price. |
Mutual funds | Moderate | Highly-traded, easy to buy/sell, low impact on price. |
ETFs | Moderate | Similar to mutual funds but typically more liquid due to stock exchange trading. |
Government bonds | Low | Typically liquid, easy to trade with stable pricing. |
Corporate bonds | Moderate to high | Varies with issuer's stability; less liquid than government bonds. |
High-yield bonds | High | Offer higher returns but with increased liquidity risk. |
Real estate | Very high | Time-consuming to sell, large transaction sizes, market-dependent. |
Alternative investments (art, antiques, etc.) | Very high | Unique, niche market, requires specific buyers, hard to liquidate. |
Cryptocurrencies | Variable | Highly variable, can be liquid but subject to market volatility and regulatory changes. |
Past performance is no guarantee of future returns.
Liquidity risk in ETFs vs mutual funds
Liquidity risk in a mutual fund becomes particularly acute when there's a surge in redemption requests from investors. In such scenarios, if the fund's assets are predominantly illiquid, the fund manager might face difficulties in quickly converting these assets into cash at their fair market value.
To protect the interests of remaining investors and manage the fund's assets effectively, the fund manager may decide to temporarily block or restrict redemptions. This action is taken to prevent forced sales of illiquid assets at undervalued prices, which could otherwise negatively impact the fund's overall value and its investors.
The fund manager of an actively managed ETF usually does not have the authority to deny redemptions. ETFs are intended to be traded on stock exchanges similar to stocks, allowing investors to buy and sell shares of the ETF throughout the trading day at market prices.
Actively managed ETFs have authorised participants (APs) who are normally large financial institutions, who help in maintaining liquidity by creating or redeeming creation units, which are large blocks of shares of the ETF. It is important, however, that one realises that during extreme market conditions, if it becomes too difficult to transact or accurately value assets underlying the ETF, then its liquidity can be affected, hence resulting in larger spreads between bid-ask prices than normal or trading at significant premium/discount relative to Net Asset Value (NAV).
To protect the interests of remaining investors and manage the fund's assets effectively, the fund manager may decide to temporarily block or restrict redemptions. This action is taken to prevent forced sales of illiquid assets at undervalued prices, which could otherwise negatively impact the fund's overall value and its investors.
The fund manager of an actively managed ETF usually does not have the authority to deny redemptions. ETFs are intended to be traded on stock exchanges similar to stocks, allowing investors to buy and sell shares of the ETF throughout the trading day at market prices.
Actively managed ETFs have authorised participants (APs) who are normally large financial institutions, who help in maintaining liquidity by creating or redeeming creation units, which are large blocks of shares of the ETF. It is important, however, that one realises that during extreme market conditions, if it becomes too difficult to transact or accurately value assets underlying the ETF, then its liquidity can be affected, hence resulting in larger spreads between bid-ask prices than normal or trading at significant premium/discount relative to Net Asset Value (NAV).
Recap
In conclusion, understanding and managing liquidity risk is crucial for both individual investors and financial institutions. The key takeaway is that liquidity risk, while often underestimated, can have significant implications on investment outcomes and financial stability. By being aware of the liquidity profiles of different investment vehicles and adopting strategies to manage this risk, investors can better prepare for and navigate the uncertainties of the financial markets.
In essence, a deep understanding of liquidity risk is a valuable component of any sound investment strategy, helping to build a more resilient and informed approach to investing.
In essence, a deep understanding of liquidity risk is a valuable component of any sound investment strategy, helping to build a more resilient and informed approach to investing.
FAQ
Q: What does liquidity risk mean?
Liquidity risk refers to the possibility that when an investor wants to convert an asset into cash in a hurry, they may lose substantial value. This risk is important for situations that require one to sell the asset quickly such as urgent need of cash and rapidly changing market conditions.
Q: Which are the two types of liquidity risk?
Funding liquidity risk and market liquidity risk are among the main forms of liquidity risks. Funding liquidity risk means the occurrence of inadequate funds when they are needed by an institution, while market liquidity risk indicates the inability to exit a trade at the prevailing price due to lack of participants or absence of depth in the market.
Q: What causes liquidity risk and how can it be prevented?
This situation arises primarily from a discrepancy between how easily an asset can be sold and how much cash is needed as soon as possible.
Furthermore, this can be minimised by following different strategies like holding liquid assets within a portfolio, understanding characteristics linked with an investment’s short-term solvency status or regular financial planning, which marries investments with cash flow requirements.
Furthermore, this can be minimised by following different strategies like holding liquid assets within a portfolio, understanding characteristics linked with an investment’s short-term solvency status or regular financial planning, which marries investments with cash flow requirements.
Q: What are common liquidity ratios and how are they calculated?
Common ratios used include:
1. Current ratio = current assets/current liabilities
2. Quick ratio=liquid assets/current liabilities
3. Cash ratio=cash+cash equivalents/current liabilities.
These figures give us insight into whether a company can meet its short-term obligations on time, thereby displaying its level of liquidity.
1. Current ratio = current assets/current liabilities
2. Quick ratio=liquid assets/current liabilities
3. Cash ratio=cash+cash equivalents/current liabilities.
These figures give us insight into whether a company can meet its short-term obligations on time, thereby displaying its level of liquidity.
Q: Why is liquidity important in investing?
Investment’s importance lies in its ability to show how simple it is for someone to convert assets into money quickly, thus affecting its price while also affecting an investor’s capacity to react instantly when circumstances change either through buying or selling or personal crises, for example.
Higher levels of liquidity normally translate into better flexibility and lower danger related to managing any form of investment.
Higher levels of liquidity normally translate into better flexibility and lower danger related to managing any form of investment.
