What does Liquidity Risk primarily refer to?

Liquidity risk primarily refers to the potential price distortions that can occur due to a lack of liquidity in the market. This type of risk arises when assets cannot be bought or sold quickly enough in the market to prevent or minimize a loss. When liquidity is low, it may lead to larger price swings as sellers may need to accept much lower prices to find buyers, or buyers may be unwilling to pay fair value for an asset due to the uncertainty of being able to sell it later without significant loss.

In markets with high liquidity, transactions can occur swiftly with minimal impact on the price of the asset. However, in less liquid markets, assets can be difficult to convert to cash at prevailing market prices, resulting in significant risks for investors or institutions that may need to quickly access cash without incurring large losses.

Understanding liquidity risk is crucial for assessing the overall risk profile of investments and for making informed financial decisions, especially in volatile market conditions.