What is liquidity risk?

All firms, particularly financial institutions, require access to borrowed funds to carry
out their operations, from paying their near-term obligations to making long-term strategic
investments. An inability to acquire such funding within a reasonable timeframe could place
a firm at risk.
Definition
Liquidity is generally defined as the ability of a financial firm to meet its debt obligations
without incurring unacceptably large losses. An example is a firm preferring to repay its
outstanding one-month commercial paper obligations by issuing new commercial paper
instead of by selling assets. Thus inability of the firm to meet its debt obligations is known as
liquidity risk. There are 2 parts to it: Funding Liquidity Risk and Market Liquidity Risk.
Funding liquidity risk is the risk that a firm will not be able to meet its current and
future cash flow and collateral needs, both expected and unexpected, without materially
affecting its daily operations or overall financial condition. Financial firms are especially
sensitive to funding liquidity risk since debt maturity transformation (for example, funding
longer-term loans or asset purchases with shorter-term deposits or debt obligations) is one
of their key business areas.
Market liquidity risk is asset illiquidity. This is an inability to easily exit a position
without making a loss. For example, we may own real estate but, owing to bad market
conditions, it can only be sold imminently at a lower price than the market price, resulting in
a loss. The asset surely has value, but as buyers have temporarily evaporated, the value
cannot be realized. Consider its virtual opposite, a U.S. Treasury bond. This bond
has extremely low liquidity risk: its owner can easily exit the position at the prevailing
market price. Small positions in S&P 500 stocks are similarly liquid. They can be quickly
exited at the market price.
In response to this well-known risk, financial firms establish and maintain liquidity
management systems to assess their prospective funding needs and ensure the funds are
available at appropriate times. A key element of these systems is monitoring and assessing
the firms current and future debt obligations and planning for any unexpected funding
needs, regardless of whether they arise from firm-specific factors, such as a drop in the
firms collateral value, or from systemic (economy-wide) factors. To balance its funding
demand, both expected and unexpected, with available supply, a firm must also incorporate
its costs and profitability targets.

Example:
Liquidity crisis during 2007-08:
Consider a bank ABC that does not have a large depositor base. It will only be able to fund
a small part of its new loans from deposits. So it will finance new loans by selling the loans
that it originated to other banks and investors. This process of selling loans is known as
securitization. ABC would then take short-term loans to fund its new loans. So the bank was
dependent on two factorsdemand for loans, which it sold to other banks, and availability
of credit in financial markets to fund those loans. When markets were under pressure in
20072008, the bank wasnt able to sell the loans it had originated. At the same time, it also
wasnt able to secure short-term credit. Due to the financial crisis, a lot of investors took out
their deposits, causing the bank to have a severe liquidity crisis since it was not able to
service its debt obligations.
Use of collaterals and liquidity risk emerging from it:
Traditionally, collaterals are assets provided to secure an obligation. A more recent
development is collateralized arrangements used to secure repurchase agreements,
securities lending and derivatives transactions. Under such a context a party who owes an
obligation to another party posts cash or securities to secure the obligation. In the event
that the party defaults on the obligation, the secured party may seize the obligation. In this
context, collateral is sometimes referred to as margin also. Because the value of the
collateral and value of the obligation can change, the secured party would typically want to
mark-to-market ie. Adjust the balances depending on the difference between the obligation
and the collateral value. In the event that the value of the collateral posted decreases
compared to the obligation, would result in a liquidity risk where in the secured party would
issue a margin call to post additional collateral.

What is Credit Risk?

The risk of loss of principal or loss of a financial reward stemming from a borrower's
failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises
whenever a borrower is expecting to use future cash flows to pay a current debt. Investors
are compensated for assuming credit risk by way of interest payments from the borrower or
issuer of a debt obligation. Credit risk is closely tied to the potential return of an investment,
the most notable being that the yields on bonds correlate strongly to their perceived credit
risk. The higher the perceived credit risk, the higher the rate of interest that investors will
demand for lending their capital. Credit risks are calculated based on the borrowers' overall
ability to repay. This calculation includes the borrowers' collateral assets, revenuegenerating ability and taxing authority (such as for government and municipal bonds).Credit
risks are a vital component of fixed-income investing, which is why ratings agencies such as
S&P, Moody's and Fitch evaluate the credit risks of thousands of corporate issuers and
municipalities on an ongoing basis.
Credit risk also denotes the volatility of losses on credit exposures in two formsthe
loss in the credit assets value and the loss in the current and future earnings from the
credit.
Example:
During the subprime crisis, many banks made significant losses in the value of loans made to
high-risk borrowerssubprime mortgage borrowers. Many high-risk borrowers couldnt
repay their loans. Also, the complex models used to predict the likelihood of credit losses
turned out to be incorrect.
Major banks all over the globe suffered similar losses due to incorrectly assessing the
likelihood of default on mortgage payments. This inability to assess or respond correctly to
credit risk resulted in companies and individuals around the world losing many billions of
U.S. dollars.

What is Counter Party Risk?

The risk to each party of a contract that the counterparty will not live up to its contractual
obligations. Counterparty risk as a risk to both parties and should be considered when
evaluating a contract. In most financial contracts, counterparty risk is also known as "default
risk".
Example:
if Joe agrees to lends funds to Mike up to a certain amount, there is an expectation that Joe
will provide the cash, and Mike will pay those funds back. There is still the counterparty risk
assumed by them both. Mike might default on the loan and not pay Joe back or Joe might
stop providing the agreed upon funds.