Definition
Liquidity risk has two dimensions: market liquidity risk (inability to trade at fair prices) and funding liquidity risk (inability to meet short-term obligations). During crises, liquidity evaporates as sellers overwhelm buyers, causing fire-sale prices. Illiquid assets (private equity, real estate, small-cap stocks) require a liquidity premium to compensate investors for this risk.
lightbulb Example
In March 2020, even U.S. Treasury markets experienced liquidity stress—bid-ask spreads widened 10x and some bonds couldn't be sold at any reasonable price. The Fed intervened with massive purchases to restore liquidity.
verified_user Key Points
- Market liquidity: ability to trade at fair prices
- Funding liquidity: ability to meet obligations
- Evaporates during crises when most needed
- Illiquid assets command a liquidity premium