Liquidity risk of a financial instrument: definition and advice

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Knowing the liquidity risk of an investment is fundamental: the higher it is, the more you run the risk of losing when you sell.

liquidity risk

There are times when selling or buying a financial instrument (stocks, bonds, ETFs, ETCs, mutual funds) can take time, be penalizing or even impossible. For example, during the collapse of Lehman Brothers selling an italian BTP was almost impossible. Today, for example, if you have a bank or corporate bond, it may take some time to sell them. If you are a client of a Premium Portfolio, you may have waited a few days before your purchase order for a simple ETF is executed by your bank. These situations are normal, because every time you invest in financial instruments you have to deal with the liquidity risk of the instruments themselves.

What is liquidity risk

Definition of liquidity risk: the ability of an investor to buy or sell a security or financial instrument on the market without affecting the price of the instrument itself.

The more an instrument is traded on the markets, the higher its degree of liquidity.

In this context, the stock exchange, as a meeting place between demand (buyer) and offer (seller), plays an important role. It is largely for this reason that a publicly traded instrument can increase the liquidity of an instrument. But it is not always enough (as in the case of many ETFs).

To capture the liquidity of an instrument, various indicators can be analyzed, which vary according to the instrument in front of you. For example, when you want to analyze the liquidity of an ETF you need to know:

  • the bid-ask spread
  • the managed mass
  • volumes and continuity of exchanges
  • the difference between physical or synthetic replication

For bonds however, the size, age of the issue or type of issuer can also be added to the list.

Why is it important to know liquidity for an investor?

Because sometimes not knowing the liquidity of your investments can cost you dearly. Imagine that, for some reason, you want to get rid of some securities or financial instruments that currently list 100. Unfortunately, at the time of the sale you realize that the liquidity of these instruments is so low that you are forced to sell them at 90, a decidedly higher price. low than you thought. A big blow to your financial wealth.

This is not always the case, but given the amount of bank bonds or unit-linked policies that the average investor has in his portfolio, they are less rare events than one might think.

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