What is Liquidity Risk and Credit Risk?

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Liquidity Risk:

The ability of an organisation, company, or even an individual to pay its debts without suffering catastrophic losses is referred to as liquidity. Liquidity risk, on the other hand, arises from an investment’s inability to be acquired or sold quickly enough to avert or reduce a loss. It frequently manifests itself in exceptionally broad bid-ask spreads or big price fluctuations.

Understanding Liquidity Risks:

The general rule is that the smaller the security or issuer, the greater the liquidity risk. Stock and other security price declines prompted many investors to sell their holdings at any price in the aftermath of the 9/11 attacks, as well as during the 2007–2008 global credit crisis. This rush to the exits resulted in wider bid-ask spreads and substantial price drops, which led to market illiquidity.

When an individual investor, corporation, or financial institution is unable to satisfy its short-term loan obligations, liquidity risk arises. Due to a shortage of buyers or an inefficient market, the investor or business may be unable to convert an asset into cash without forfeiting capital and income.

Credit Risk

The likelihood of a loss due to a borrower’s failure to repay a loan or satisfy contractual commitments is referred to as credit risk. It traditionally refers to the risk that a lender will not obtain the owed principal and interest, resulting in a disruption in cash flows and increased collection costs. Excess cash flows can be written to give further credit risk protection. When a lender faces more credit risk, it can be addressed by offering a higher coupon rate, which results in higher cash flows.

Although it is hard to predict who will fail on obligations, correctly analysing and managing credit risk can help to mitigate the severity of a loss. Interest payments from a debt obligation’s borrower or issuer are a lender’s or investor’s incentive for taking on credit risk.

Understanding Credit Risk

There is a danger that the borrower may not repay the debt when lenders give mortgages, credit cards, or other sorts of loans. Similarly, if a corporation extends credit to a consumer, there is a chance that the customer will fail to pay their bills. Credit risk also refers to the possibility that a bond issuer will fail to make a required payment or that an insurance company will be unable to pay a claim.

Credit risks are estimated based on the borrower’s overall capacity to repay a loan in accordance with the terms of the original loan. Lenders consider the five Cs when assessing credit risk on a consumer loan: credit history, repayment capacity, capital, loan terms, and collateral.

Some businesses have created departments that are completely responsible for assessing the credit risks of their current and prospective clients. Businesses may now swiftly examine data needed to estimate a customer’s risk profile thanks to advances in technology.

When an investor contemplates purchasing a bond, they will frequently look at the bond’s credit rating. If the rating is low (BBB), the issuer is at a high risk of default. Conversely, if it has a higher rating (BBB, A, AA, or AAA), the danger of default decreases gradually.

Bond rating organisations, such as Moody’s Investors Service and Fitch Ratings, continuously assess the credit risks of hundreds of corporate bond issuers and municipalities.

A risk-averse investor, for example, may choose to purchase a AAA-rated municipal bond. A risk-taking investor, on the other hand, may purchase a bond with a lower rating in exchange for potentially larger returns.

Also Read: Harness the power of compounding through proper asset allocation

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