What does the term ‘liquidity risk’ refer to?

Liquidity risk is primarily concerned with the ease of converting an asset into cash without incurring substantial costs or losses in value. The correct understanding of liquidity risk highlights that it is not merely about price declines or valuations, but specifically pertains to how quickly one can sell an asset. If an asset cannot be sold quickly or only at a significantly reduced price, this creates a liquidity risk for the holder.

For instance, in a market downturn, certain assets may get trapped if there are not enough buyers. This situation emphasizes the importance of liquidity for investors or entities that may need to access cash quickly. Hence, the definition provided by the correct choice accurately encapsulates the nature of liquidity risk as it relates to the challenges an asset may pose when immediate cash is needed.

Other options may touch upon related concepts—such as value loss or borrower default—but they do not capture the specific nature of liquidity risk, which is exclusively about the timing and cost of converting assets to cash in a marketplace.