LO 52.1: Define liquidity risk and describe factors that influence liquidity,

LO 52.1: Define liquidity risk and describe factors that influence liquidity, including the bid-ask spread.
Liquidity risk is the degree to which a trader cannot trade a position without excess cost, risk, or inconvenience. When liquidity risk exists, there can be several types of price uncertainty. First, the usual market quote of the average of the bid and ask prices becomes less meaningful because the spread is wider, which means the market quote is even farther from either the buy or sell transaction price. Second, a larger bid-ask spread means a higher cost to get in and out of the position. Third, the actual price of either a buy or sell order is less certain because the assets do not trade frequently, and the quoted bid and ask prices will probably not be the prices of the respective sell and buy transactions when actually executed. There is also an increased risk in that the spread can change (i.e., it is stochastic), which will increase the risks of trading.
Liquidity is a function of the type of market and its characteristics. It depends on factors such as the number of traders in the market, the frequency and size of trades, the time it takes to carry out a trade, the cost, and the risk of the transaction not being completed. It also depends on the type of asset and the degree to which the asset is standardized. A less standardized asset will have higher liquidity risk. A forward contract has much more liquidity risk than a futures contract, for example, because the forward contract is not a standardized contract. Over-the-counter (OTC) derivatives of all types usually have relatively high liquidity risk.
B i d – A s k S p r e a d
The bid-ask spread is a cost of liquidity. A wider (narrower) spread indicates lower (higher) liquidity. If an asset becomes less liquid, the spread increases, and the costs of trading the asset increase. The risk of liquidity changing, and changes in the spread, should be included with other measures of market risk. The spread can also change as a result of the activities of a given trader when liquidity is endogenous, which is described in the next LO.
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Topic 52 Cross Reference to GARP Assigned Reading – Dowd, Chapter 14
E x o g e n o u s v s . E n d o g e n o u s L i q u i d i t y

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