What does liquidity risk refer to?

Liquidity risk specifically refers to the potential difficulty that an institution may face in meeting its short-term financial obligations due to an inability to convert assets into cash quickly without incurring significant losses. This type of risk highlights the concern that, at a given point in time, there may not be enough cash or liquid assets available to satisfy immediate liabilities or obligations.

Financial institutions and businesses must maintain a certain level of liquidity to ensure they can meet their expected cash flow requirements. If an institution encounters liquidity risk, it might struggle to sell its assets, or it may have to sell them at a discount, which could harm its financial standing. This concept is critical in risk management, as liquidity issues can lead to solvency problems, if not adequately addressed.

While other options may relate to various aspects of financial risk, none define liquidity risk as accurately as the statement about meeting short-term financial obligations.