Liquidity risk is a term that is used to describe the financial vulnerability that is encountered by businesses during asset disposal. Generally, it is used to mean the financial risk that might arise when a business attempts to sell its assets mainly because of the nature of the asset or other difficulties that might prevent the desired returns on the asset (Pedersen 5). Liquidity risk in this context is therefore dependent on various factors such as the nature of the asset that is being disposed of, credit ratings of the company, and the prevailing market environment at the time of liquidation that might combine to prevent disposal at a favorable price (Pedersen 6).
There are two major types of liquidity risk in financial management: asset liquidity and funding liquidity (Pedersen 2). Asset liquidity risk is more or less what we have discussed above and primarily involves assets that cannot easily be liquidated in the market, on the other hand, funding liquidity refers to risks that emanate from company liabilities where business financial performance cannot effectively meet its current liabilities. Funding liquidity is usually expressed through liquidity ratio which determines the ability of a business to meet its short-term liabilities. In other words, it is a ratio that is used to determine how well that a business can pay its immediate creditors by examining the cash flow volumes (Pedersen). As such it is usually important for any business to be able to determine the liquidity risk of its assets as well as its liabilities.
In the banking industry liquidity is a concept that is used to calculate the right mix that enables financial institutions to strike a balance between meeting their financial obligations on time, at a low cost while increasing their capital base at the same time (Onorato 26). In the banking industry, liquidity risk is even more of an existing threat than is the case in other businesses due to the nature of its business operations; it is for these reasons that financial institutions are more vulnerable to liquidity risk. Routine business operations demand financial institutions to constantly trade with assets for purposes of investments, or as collateral that can be ideally disposed at short notice to meet its short-term liabilities (Onorato 24). Besides, banks’ major operations involve investments of its customers’ deposits that are usually held in assets; determination of low liquidity risk type of asset is, therefore, most paramount for these institutions.
The actual cause of liquidity risk cannot be easily pinpointed since it is brought about by various factors that interact together to influence the market conditions of the product or asset in that case. However, liquidity risk is not entirely caused by the market environment such as low demand and higher supply; at times it is a result of the inability of buyers and sellers to locate each other to complete the sale transaction (Pedersen 3). At other times, a company might be unable to liquidate its assets as a result of low credit ratings, erosion of share value, or credit crunch as it recently happened in 2009, indeed many causes can lead to liquidity risk (Pedersen 3).
Determination of Liquidity Risk
Besides liquidity ratio which is slightly a different concept, two other methods are used to measure liquidity risk of a business: liquidity gap and liquidity risk elasticity (Onorato 32). The liquidity gap refers to the total assets of a company that can be liquidated at any given time minus its short-term liabilities.
A negative liquidity gap, therefore, means that a firm is not able to meet its liabilities at once and indicates vulnerability from liquidity risk. Liquidity Risk Elasticity is the other type that is primarily used in financial institutions to measure liquidity risk. It measures the change in liquidity assets value that occurs when a bank’s liquidity premium is increased by a small margin. In both of these methods, the idea is to test the vulnerability of the firm against the risks of liquidity based on two primary variables: capital asset and volatile liabilities (Onorato 28).
Determination of Asset Liquidity
An equally important area in liquidity risk management involves the measurement of a firm’s asset liquidity, this is to ensure that prospective assets can be disposed of at short notice at the desired price. Similar to the determination of liquidity risk, the methods that are used in this case vary and usually involve a combination of several of them which include determination of market depth, immediacy, resilience, and bid-offer spread (Pedersen 4). Immediacy is a method that is used when one wants to determine the time duration and ideal moment that is required before an asset can be liquidated at the right price.
The bid-offer spread is a measure that utilizes the ratio concept to determine the relative liquidity level of an asset; a lower ratio number indicates a high liquid asset (Pedersen 4). Resilience is also a very effective method of gauging asset liquidity; it is the time taken by the market of a certain commodity to revert to normal price range after significant amounts of the particular asset have been floated (Pedersen). Finally, market depth is used to examine the ability of a market to absorb similar assets at various prices which is an indication of a liquid asset.
Liquidity Risk Management
The necessity of identifying the most ideal asset to invest in is what entails the principles of liquidity risk management. Management of liquidity risk is essentially a complicated process that intends to determine the right balance of investments portfolio through best business practices by projecting future market dynamics among other factors to reduce liquidity risk. In theory, it involves the application of several financial models that are used to calculate specific indicators of interest. The most common of these models include determination of liquidity at risk, liquidity-adjusted values at risk (VAR), diversification of liquidity strategies, derivatives, and case scenario analysis (Pedersen 6).
Liquidity-adjusted VAR is used to transform the liquidity risk to VAR which is then summed up with Exogenous Liquidity Cost (ELC) to determine the safety risk levels. The liquidity at Risk option on the other hand is used to calculate safe foreign reserve levels for countries based on various factors such as commodity price, exchange rates credit spreads among others. But perhaps the most ideal option for mitigating liquidity risk is contained in the “five derivatives” model which describes a total of five options that businesses can utilize to reduce liquidity risk i.e. return swap, withdrawal option, return swaption, Bermudan-style, and liquidity option (Pedersen).
Onorato, Mario. Liquidity Risk Management: Assessing and Planning for Adverse Events, 2007. Web.
Pedersen, Lasse. Market Liquidity and Funding Liquidity. Review of Financial Studies 22.6 (2009): 2201–2238. Web.