What does liquidity risk refer to?

Liquidity risk refers specifically to the possibility that an asset cannot be quickly converted into cash without incurring a substantial loss in value. This risk is especially pertinent in situations where an investor may need to sell an asset urgently due to unforeseen circumstances, and a lack of market demand may lead to a forced sale at a lower price.

Understanding liquidity risk is crucial for investors and financial professionals because it impacts the overall stability of their asset portfolio. Assets that are highly liquid, like stocks of large companies or government bonds, can be sold easily and quickly, maintaining their market value. Conversely, illiquid assets, such as real estate or collectibles, may require significant time to sell, and the price may vary dramatically based on market conditions at the time of sale.

The other options reflect different types of risks but do not accurately define liquidity risk. For instance, the first option pertains to market risk or investment risk rather than liquidity. The choice regarding holding cash too long touches on opportunity cost rather than the risks associated with liquidity. Lastly, the risk of debtor defaults is related to credit risk rather than liquidity risk. Hence, option B appropriately captures the essence of liquidity risk.