liquidity risk

Examples of liquidity risk in the following topics:

• The Imperative of Liquidity

  • 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.

• Commercial Banks

  • 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.

• Global finance: initial considerations

  • In addition, the foreign exchange market is one of the most traded and liquid instruments in the financial world, and serves as a barometer of broader financial market conditions and risk appetite.
  • Currency risk is the potential consequence from an adverse movement in foreign exchange rates (Coyle, 2000).
  • Common ways of hedging currency risk involve:
  • transferring the risk to your trading partner by placing the transaction in your domestic currency
  • structurally hedging your risk by off setting income against expenditure in the same currency

• Day-to-Day Needs

  • "Cash and cash equivalents" on the balance sheet are the most liquid assets found on this statement.
  • Cash equivalents are distinguished from other investments through their short-term existence; they mature within three months and have insignificant risk of change in value.
  • Cash flow forecasting or cash flow management is a key aspect of the financial management of a business, because planning for future cash requirements can help to avoid a liquidity crisis in the business.
  • Liquidity is essential for businesses, because it allows them to meet daily operating needs.

• Credit Unions

  • As a result, credit unions tend to be smaller forms of cooperative banks that avoid borrowing, and operate solely upon the funding and liquidity enabled by the resources deposited by members.
  • Credit unions pride themselves on being community-oriented, deliberately mitigating risk and serving people as opposed to pursuing profit.
  • Credit unions are more vulnerable to risk, and thus may not be as willing as larger banks to lend money without confidence in repayment
  • Big banks add advantage through scale (along with risk), providing more investment opportunities and global access to capital.
  • Assess the value of credit unions, particularly compared to big banks and an understanding of risk

• The Lender of Last Resort

  • It took over this role from the private sector "clearing houses" which operated during the Free Banking Era; whether public or private, the availability of liquidity was intended to prevent bank runs.
  • According to the Federal Reserve Bank of Minneapolis, "the Federal Reserve has the authority and financial resources to act as 'lender of last resort' by extending credit to depository institutions or to other entities in unusual circumstances involving a national or regional emergency, where failure to obtain credit would have a severe adverse impact on the economy. " Through its discount and credit operations, Reserve Banks provide liquidity to banks to meet short-term needs stemming from seasonal fluctuations in deposits or unexpected withdrawals.
  • Longer term liquidity may also be provided in exceptional circumstances.
  • The Federal Reserve System's role as lender of last resort has been criticized because it shifts the risk and responsibility away from lenders and borrowers and places it on others in the form of inflation.

• Equity Finance

  • Companies can use equity financing to raise money and/or increase shareholder liquidity (through an IPO).
  • Just as landlords seek rents on their property, capital providers seek returns on their funds, which must be commensurate with the risk undertaken.
  • According to finance theory, as a firm's risk increases/decreases, its cost of capital increases/decreases.
  • Such providers are usually rational and prudent preferring safety over risk.
  • If an investment's risk increases, capital providers demand higher returns or they will place their capital elsewhere.

• Information and Risk Trade-Off

  • IT risk relates to the business risk associated with the use, ownership, operation, involvement, and adoption of IT within an enterprise.
  • Risk is the product of the likelihood of an occurrence times its impact (Risk = Likelihood x Impact).
  • IT risk management can be viewed as a component of a wider enterprise risk management (ERM) system.
  • IT risk transverses all four of the aforementioned categories and should be managed within the framework of enterprise risk management.
  • Risk appetite and risk sensitivity of the whole enterprise should guide the IT risk management process.

• Sample Evaluation

  • This demonstrates that the company does not seem to be in a tight position in terms of liquidity.
  • This means that the company may face liquidity problems should payment of current liabilities be demanded immediately.
  • The higher the ratio, the greater risk will be associated with the firm's operation.

• Owners' Equity

  • This definition is helpful in understanding the liquidation process in case of bankruptcy.
  • Ownership equity is also known as risk capital or liable capital.