Which statement best defines liquidity risk?

Which statement best defines liquidity risk?

• A. The risk that an entity will have difficulty paying financial liabilities settled with cash or other financial assets.
• B. The possibility of a loss resulting from a borrower's failure to repay an amount owed or meet a contractual obligation.
• C. The risk that the fair value of future cash flows of a financial instrument will fluctuate because of changes in market prices.
• D. The present value of the cash flows from the use of an asset and its disposal.

Answer: (A)

Liquidity risk is the risk that an entity will have difficulty paying financial liabilities as they come due because it cannot quickly convert assets to cash or access funding. The statement that best defines this risk describes the potential inability to settle obligations with cash or other readily marketable financial assets. The other descriptions point to different risks: one refers to credit risk (borrower default), another to market risk (fluctuations in fair value due to market moves), and the last to asset valuation related to the asset’s use and disposal rather than the ability to meet obligations. For example, a company facing upcoming payments but lacking sufficient liquid cash or easily sellable assets would be confronting liquidity risk.

Liquidity risk is the risk that an entity will have difficulty paying financial liabilities as they come due because it cannot quickly convert assets to cash or access funding. The statement that best defines this risk describes the potential inability to settle obligations with cash or other readily marketable financial assets. The other descriptions point to different risks: one refers to credit risk (borrower default), another to market risk (fluctuations in fair value due to market moves), and the last to asset valuation related to the asset’s use and disposal rather than the ability to meet obligations. For example, a company facing upcoming payments but lacking sufficient liquid cash or easily sellable assets would be confronting liquidity risk.