Market Liquidity Risk

Market liquidity risk is the risk that an investor will be unable to buy or sell an asset quickly without causing a significant change in its price. In the world of derivatives and structured products, this risk is often elevated because many of these instruments are bespoke or trade in over-the-counter markets with limited participants.

When liquidity dries up, it becomes difficult to exit positions, leading to "fire sale" scenarios where prices plummet as holders scramble to exit. This risk is a major component of the total risk of any credit-linked product, as the ability to hedge or close a position is often assumed in theoretical models but may not exist in practice during a crisis.

Managing liquidity risk requires maintaining sufficient cash buffers and avoiding over-concentration in illiquid assets that cannot be easily offloaded during periods of market stress.