Examples of liquidity risk in the following topics:
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- To accurately frame the discussion of cash flows, an understanding of liquidity is integral.
- When considering cash flow, it is important to understand liquidity risk.
- The difficulty in taking a certain asset to market, and recovering capital without incurring a loss of value, is called liquidity risk.
- All investments of capital can be framed with three key attributes: average expected return, degree of risk, and overall liquidity.
- This chart shows some estimations of various types of capital investments, alongside their respective risk, return, and liquidity.
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- There are many types of financial risk, including asset-backed, prepayment, interest rate, credit, liquidity, market, operational, foreign, and model risk.
- Prepayment risk is the risk that the buyer goes ahead and pays off the mortgage.
- Credit risk or default risk, is the risk that a borrower will default (or stop making payments).
- Liquidity risk is the risk that an asset or security cannot be converted into cash in a timely manner.
- Some investments (i.e. stocks) can be sold immediately at the current market rate and others (i.e. houses) are subject to a much higher degree of liquidity risk.
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- Risk management (i.e. foreign exchange risks, interest rates, hedging commodities, derivatives)
- Credit Risk – Risk that a borrower may not return the entirety of the payment owed.
- Liquidity Risk – Risk that an acquired asset cannot be traded quickly enough to capture profit.
- Market Risk – Virtually any capital asset has a market, and is therefore subjected to the risks of it's respective market.
- Operational Risk – Risk that an operational issue will diminish returns.
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- Bonds are subject to risks such as the interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.
- Bonds are also subject to various other risks such as call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk, and yield curve risk.
- As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.
- Under the laws of many countries (including the United States and Canada), bondholders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors.
- In a bankruptcy involving reorganization or recapitalization, as opposed to liquidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.
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- Market interest rates are mostly driven by inflationary expectations, alternative investments, risk of investment, and liquidity preference.
- Risks of investment: There is always a risk that the borrower will go bankruptcy, abscond, die, or otherwise default on the loan.
- The greater the risk is, the higher the market interest rate will get.
- where in is the nominal interest rate on a given investment, ir is the risk-free return to capital, pe = inflationary expectations, i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S.
- Treasury Bills), rp = a risk premium reflecting the length of the investment and the likelihood the borrower will default, lp = liquidity premium (reflecting the perceived difficulty of converting the asset into money and thus into goods).
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- Investors are usually risk averse.
- Consequently, bond prices increase for the lower-risk bonds but decrease for the higher-risk bonds.
- Furthermore, the interest rates are lower for the low-risk bonds and higher for the high-risk bonds.
- Consequently, bond prices increase for the liquid bonds but decrease for the non-liquid bonds.
- Thus, the securities have the same risk, liquidity, information costs, and taxes.
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- Liquidity causes bond prices and interest rates to differ.
- For instance, U.S. government securities are widely traded and are the most liquid.
- Consequently, we use a similar analysis to default risk, which we have explained in the previous section.
- Taking the difference between the two interest rates, we measure the degree of liquidity.
- Nevertheless, economists refer the difference in interest rates as a risk premium.
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- Businesses and governments offer a variety of bonds that differ in default risk, liquidity, information costs, and taxes.
- Risk premium is always positive.
- As the default risk increases, then the risk premium increases too.
- During recessions, when some businesses bankrupt, the default risk increases, increasing the risk premium.
- Impact of a risk premium on the bond markets
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- As a result, the portion of risk that is unsystematic -- or risk that can be diversified away -- does not require additional compensation in terms of expected return.
- However, if unexpected business risks lead to liquidity problems, the company might go bankrupt and default on its loans.
- This type of risk cannot be diversified away, and is referred to as systematic risk.
- This is the portion of risk that pays the risk premium, because the risk associated with this particular segment of the market is more tightly linked to the risk of the market as a whole.
- Diversification theory says that the only risk that earns a risk premium is that which can't be diversified away.
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- If one bond market has a high risk while the other is low risk, then how does risk impact the bond markets?
- If one bond market were highly liquid while the other market has low liquidity,subsequently, how would liquidity impact the bond markets?