What does liquidity risk involve?

Liquidity risk pertains specifically to the potential difficulty of quickly selling an asset without realizing a substantial loss in value. This type of risk is crucial for investors who may need to access cash quickly or who are operating in markets where there is not a high volume of buyers or sellers. In situations where market demand is low, an investor may be forced to sell an asset at a significant discount, thereby incurring a loss that may not be reflective of the asset’s intrinsic value.

Market conditions can sometimes lead to a discrepancy between an asset's market price and its underlying value, particularly in environments where sellers outnumber buyers. This could manifest in various ways, such as during financial crises or periods of economic uncertainty, when the general market for certain types of assets may dry up, leading to higher transaction costs and greater price volatility.

In contrast, the other choices represent different types of risks. Fluctuations in asset prices relate to market volatility, while the risk of default concerns the borrower's ability to meet financial obligations. Interest rate risk involves the changes in interest rates that can negatively impact asset values. Thus, liquidity risk is distinct in that it focuses specifically on the ability to convert assets into cash swiftly and the potential losses incurred in doing so, making the first