What is liquidity risk?

Liquidity risk refers to the risk that an entity will not be able to meet its short-term financial obligations due to an inability to convert assets into cash without a significant loss in value. This means that if a company is unable to access sufficient cash or liquid assets when needed, it may face challenges in paying off debts or financing operations.

Understanding liquidity risk is crucial for financial institutions and businesses alike because, even if a company is profitable on an operational level, having inadequate liquid assets can lead to insolvency or financial distress during periods of cash flow shortages. Companies need to manage their liquidity positions carefully to ensure they can cover immediate cash requirements, especially during adverse market conditions.

The other choices address different types of risks: market fluctuations pertain to market risk, creditworthiness is linked to credit risk, and technology failures involve operational risk. These categories are distinct, highlighting the specific focus of liquidity risk on the availability of cash and liquid assets to meet obligations.