What is 'liquidity risk'?

Liquidity risk refers to the possibility of not being able to sell an asset quickly enough without causing a significant decline in its market price. This type of risk is particularly relevant in financial markets where certain assets may not have many buyers at a given time. When an asset is illiquid, it can lead to a situation where the owner has to take a lower price to sell it promptly, which may result in a loss or worse valuation.

Understanding liquidity risk is crucial for investors and traders, as it can affect their ability to execute transactions, respond to market changes, and manage their portfolios effectively. This risk becomes particularly important in periods of financial stress when more investors may be looking to sell assets simultaneously, further exacerbating the problem.

In contrast, the other options reflect different types of risks. For example, losing money during a market downturn involves market risk, interest rate changes relate to interest rate risk, and compliance with financial regulations pertains to regulatory risk. Each of these has its own specific implications, but they do not directly define liquidity risk.