30 Oct, 2025
5 mins read
Liquidity risk is one of the most critical yet often overlooked aspects of investing and financial planning. It plays a vital role in shaping investment decisions, influencing everything from market behaviour to personal finance outcomes. In this blog, we break down what liquidity risk means, its types, causes, real-life examples, and how investors can manage it effectively.
Liquidity risk refers to the potential difficulty an investor or institution may face in converting an asset into cash without significantly impacting its price. In simpler terms, it's the risk that you may not be able to sell an asset quickly at its fair market value.
For individuals, this could mean being unable to access funds during emergencies because their money is tied up in illiquid investments. For financial institutions, it could lead to challenges in meeting short-term obligations, which may affect solvency.
Liquidity is essential for smooth functioning in both markets and corporate finance. Higher liquidity ensures easier transactions, while low liquidity may trap investors in positions they can’t easily exit.
Liquidity risk can be broadly divided into two categories:
This type of risk arises when an investor is unable to sell an asset due to low trading volumes or lack of buyers. It becomes more pronounced during periods of market volatility.
For example, a stock with limited trading activity may see large price drops if several investors try to sell at the same time.
This refers to the risk that a firm or investor may not have sufficient cash or liquid assets to meet short-term liabilities. Even profitable businesses can face funding issues if their assets are tied up or not easily convertible to cash.
It’s particularly relevant for banks, which must always ensure they can meet withdrawal demands and other immediate obligations.
Several factors can trigger or worsen liquidity risk:
Market volatility: Sudden shifts in market sentiment can lead to a drying up of buyers or sellers.
Economic downturns: Recessions or financial crises reduce confidence and trading activity, making it harder to liquidate assets.
High concentration in illiquid assets: Investing heavily in real estate, unlisted shares, or small-cap stocks can increase exposure.
Debt maturity mismatch: Borrowing short-term funds to invest in long-term assets can create liquidity gaps.
Bank runs or panic withdrawals: For financial institutions, mass withdrawals can strain liquidity even if underlying assets are sound.
A trader holds a large position in a small-cap stock with low daily volume. When attempting to sell during a market downturn, they may not find buyers, or the stock may drop sharply, leading to a loss.
Property is typically illiquid. If an investor needs urgent cash, selling a property quickly without a discount is difficult, especially in a weak market.
In India, mutual funds that invest in less liquid assets like corporate debt may face redemption pressures during market stress, forcing them to sell holdings at a loss. This was evident during the Franklin Templeton debt fund crisis in 2020.
A bank may face a liquidity crunch if many depositors withdraw funds simultaneously. Despite having enough long-term assets, it may struggle to meet short-term liabilities.
Effective liquidity management is crucial for individuals, investors, and institutions. Here’s how you can mitigate the risk:
Always keep some funds in highly liquid instruments like savings accounts or short-term deposits to handle unexpected expenses.
Avoid investing all your money in illiquid assets. A mix of liquid and long-term investments helps you stay flexible.
Before investing, assess how easily an asset can be converted into cash. Stocks on major exchanges are more liquid than real estate or private equity.
For fixed income instruments, use a laddering approach where bonds or deposits mature at regular intervals. This ensures regular cash flow.
Individuals and businesses should monitor income and expense patterns to ensure enough liquidity is maintained to meet obligations.
Financial institutions use liquidity stress testing to evaluate how they would perform during adverse scenarios. Investors can apply a simpler version by asking: “What if I had to sell this investment today?”
Liquidity risk affects everyone from individual investors to large institutions. While it may not always be visible during stable periods, its impact becomes stark during financial stress. By understanding the causes, recognising the signs, and applying sound financial strategies, one can manage this risk effectively. Remember, having high returns is valuable, but the ability to access your money when needed is equally important.
Liquidity risk is the chance that you may not be able to quickly convert an investment into cash without a significant loss. For example, selling a house urgently may force you to accept a lower price due to lack of immediate buyers.
If a mutual fund invests in illiquid assets and many investors redeem at once, the fund may struggle to sell assets at fair prices. This can lead to temporary suspension of redemptions or losses for remaining investors. Hence, fund selection and asset transparency are key.
Look at the stock’s average daily trading volume and bid-ask spread. A higher volume and tighter spread usually indicate better liquidity. Stocks listed on major indices or exchanges tend to be more liquid.
Market liquidity refers to how easily assets can be bought or sold in the market without affecting their price. Funding liquidity, on the other hand, is the ability of a company or investor to meet short-term financial obligations using available cash or liquid assets.
Calculate your Net P&L after deducting all the charges like Tax, Brokerage, etc.
Find your required margin.
Calculate the average price you paid for a stock and determine your total cost.
Estimate your investment growth. Calculate potential returns on one-time investments.
Forecast your investment returns. Understand potential growth with regular contributions.
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