Bulls n' Bears

Understanding Risks due to Liquidity

Investment involves taking risks and one of the common risks associated with any investment is the risk due to liquidity. The risks associated with liquidity are very critical, because the individual investors capitalize only where there is expectation that the funds to be refunded upon maturity of the specific capital investment. The investors’ purchases some securities that they expect that the company would meet its financial obligations and one that would be able to redeem the specific capital investment for cash in future.

When investors’ wealth is tied up in capital investments such as land and may need to be converted into cash, one may have to wait for months to be able to get an offer that an investor believes it is worth. Effective liquidity risk management is quite imperative in capital investment especially during the financial stress periods. Markets are becoming illiquid and investments are finding it hard to fund themselves.
Liquidity of a specific capital investment fluctuates over a period of time and across the market.

The most common market liquidity risk when dealers in financial institutions stop trading in bonds or in situations when bids are shut down. This has become a common occurrence for capital investments especially for asset backed securities and convertible bonds. Banks are usually the main source of funding for such capital investments. The global crisis has resulted in banks being unable to fund capital investments because they are experiencing serious funding liquidity risks.

Liquidity is the yardstick to measure the well-being of the capital market. Investors and regulators are becoming more aware on the risks due to liquidity. More energy is refocused on the measures and re- evaluation of risks associated with liquidity within the asset funds. Financial institutions should be able to fund liquidity. This should be adequate even in a situation where investors redeem huge sums that were not expected than the funds asset can support. Investors should target securities that can be converted easily with no risk of hurting the specific capital investment in a portfolio. Some of the recommended capital investments that have no serious risk due to liquidity are mutual funds, corporate bonds and money market funds.