What is liquidity risk?

Liquidity risk refers to the possibility that an investor may face difficulty in quickly buying or selling an investment without causing a significant impact on its price. This risk is particularly relevant in the context of assets that do not trade frequently or have a limited market base, which can lead to situations where investors are unable to execute transactions at desired prices.

Understanding liquidity risk is crucial for investment strategies because a lack of liquidity can result in considerable price drops when trying to sell large volumes of an asset, or may force an investor to accept less favorable prices. Essentially, liquidity is the measure of how easily an asset can be converted to cash without affecting its market price, making this risk an important consideration in financial markets.

The other options describe different types of risks: the loss of capital pertains to default risk or investment risk in general, interest rate fluctuations represent interest rate risk, and insufficient cash flow relates to liquidity in terms of meeting obligations. Each of these deals with different facets of investment and finance, but they do not specifically define liquidity risk as it pertains to the ease of trading assets.