What does the term "liquidity risk" refer to?

Liquidity risk refers to the potential difficulty in selling an asset quickly without causing a significant drop in its price. When an asset has high liquidity, it means that it can be readily sold in the market with minimal price impact, while low liquidity indicates that finding a buyer may take more time or could necessitate selling at a discount to the asset's true value. Understanding liquidity risk is crucial for investors, as it can significantly affect their ability to respond to market conditions or manage cash flow requirements.

In the context of financial investments, liquidity risk comes into play particularly for assets that are not frequently traded, such as certain real estate investments or shares of smaller companies. Investors need to be aware of how easily they can convert their investments to cash, especially in times of market stress.