What does liquidity risk mean, and which is a classic example?

What does liquidity risk mean, and which is a classic example?

• A. Risk that long-term obligations cannot be met.
• B. Risk that an entity cannot meet short-term obligations; example: a bank run or insufficient cash.
• C. Risk due to exchange rate fluctuations.
• D. Risk that profits will not be realized due to market risk.

Answer: (B)

Liquidity risk is the risk that an entity cannot meet its short-term obligations as they come due because it lacks sufficient cash or easily tradable assets, or cannot quickly convert assets into cash without taking a big loss. A classic illustration is not having enough cash on hand to cover daily expenses or a bank run, where investors rush to withdraw funds and liquidity dries up. This choice directly captures the idea of immediate cash flow problems and the need to access cash quickly. The other scenarios describe different risks. Not being able to meet long-term obligations points to solvency concerns, not the day-to-day cash flow issue that liquidity risk targets. Exchange rate fluctuations involve currency risk, while profits potentially not being realized due to market movements reflect market risk, not the ability to access cash when needed.

Liquidity risk is the risk that an entity cannot meet its short-term obligations as they come due because it lacks sufficient cash or easily tradable assets, or cannot quickly convert assets into cash without taking a big loss. A classic illustration is not having enough cash on hand to cover daily expenses or a bank run, where investors rush to withdraw funds and liquidity dries up. This choice directly captures the idea of immediate cash flow problems and the need to access cash quickly.

The other scenarios describe different risks. Not being able to meet long-term obligations points to solvency concerns, not the day-to-day cash flow issue that liquidity risk targets. Exchange rate fluctuations involve currency risk, while profits potentially not being realized due to market movements reflect market risk, not the ability to access cash when needed.