What is Liquidity Risk in Mutual Fund?

Liquidity risk is defined as the difficulty an investor or institution may face in buying or selling an asset at its market value. This risk occurs when low market activity leads to a significant drop in an asset’s price. Effective liquidity risk management involves identifying and addressing these risks to minimise their impact. 
 

Types of Liquidity Risk 

Following are the different types of liquidity risk: 

• Market Liquidity Risk: This occurs when an asset is difficult to trade due to a lack of buyers or sellers. For example, a thinly traded stock may have high market liquidity risk. 
• Funding Liquidity Risk: This arises when an institution struggles to meet short-term financial obligations due to insufficient cash or liquid assets. A company facing financial difficulties may experience funding liquidity risk. 
• Transaction Liquidity Risk: This occurs when a large transaction cannot be completed quickly at the desired price, often due to a lack of buyers or sellers. For example, selling a large block of shares may be challenging without impacting the price. 

 

Example of Liquidity Risk 

A common example of liquidity risk occurs when an investor holds a substantial position in a stock with low trading volume. Attempting to sell a large quantity of this stock may lead to a decrease in its price due to insufficient demand, resulting in a sale price lower than anticipated. 
 

How is Liquidity Risk Measured? 

Liquidity risk is measured using several methods: 

• Bid-Ask Spread: The difference between the buying price (bid) and selling price (ask) of an asset can indicate its liquidity. A larger spread often signifies higher liquidity risk. 
• Market Depth: This refers to the volume of buy and sell orders at various price levels. A market with deep order books is generally more liquid. 
• Turnover Ratio: This measures the volume of trading activity relative to the total number of outstanding shares. Higher turnover ratios suggest better liquidity risk solutions.