Liquidity risk is the risk that a company will not be able to meet its financial obligations as they come due. This can happen for a number of reasons, including a sudden decrease in the value of the company's assets, a sudden increase in the company's liabilities, or a decrease in the company's ability to generate cash flow. Liquidity risk can have a number of negative consequences, including bankruptcy, default on loans, and a loss of confidence from investors.
There are a number of different types of liquidity risk, each with its own set of potential consequences. The most common types of liquidity risk are market risk, credit risk, and funding risk.
Market risk is the risk that a company will not be able to sell its assets at a price that covers its liabilities. This can happen if there is a sudden decrease in the demand for the company's products or services, or if the company's assets are suddenly worth less than the company's liabilities.
Credit risk is the risk that a company will not be able to repay its debts as they come due.
Funding risk is the risk that a company will not be able to raise the capital it needs to meet its financial obligations.
Liquidity risk can have a number of negative consequences, including bankruptcy, default on loans, and a loss of confidence from investors. Liquidity risk can also lead to a decrease in the value of the company's stock, a decrease in the company's credit rating, and an increase in the cost of borrowing.
There are a number of ways to manage liquidity risk. Some companies choose to hold more cash than they need to meet their short-term obligations, in order to be prepared for a sudden decrease in the value of their assets or a sudden increase in their liabilities. Other companies choose to invest in short-term instruments, such as government bonds, to provide a source of funds in case of a liquidity crisis. Still other companies choose to enter into hedging contracts, such as interest rate swaps, to protect themselves from the risk of a sudden change in interest rates.
The 2007-2008 financial crisis was caused by a number of factors, including excessive leverage, risky mortgage products, and weak underwriting standards. However, one of the most important factors was the lack of liquidity in the financial system. When the value of mortgage-backed securities began to decline, many banks and other financial institutions found themselves unable to meet their financial obligations. This led to a wave of bankruptcies and defaults, and ultimately to the collapse of the global financial system.