Finance Essay Example | Topics and Well Written Essays - 2250 words

Finance - Essay Example Overview The term liquidity refers to the ability of the firm to cover its debt obligations through its liquid assets, without incurring a large loss. For example, if a firm wants to repay its outstanding commercial paper obligation of one month, then it might issue new commercial papers instead of selling its assets (The Economist 2001). Thus, liquidity risk involves the inability of the firm to meet its current and its future collateral needs and cash flows, without affecting the overall financial operations of the firm (FRBSF 2010, 1). The financial firms are generally sensitive regarding funding the liquidity risks, as transforming debt maturity such as purchasing assets with the short-term deposits, funding the long-term loans or debt obligations, are the major business areas. As a response to the liquidity risk, the financial firms generally maintain and establish a system for liquidity management. This system helps in assessing the prospective requirements of funds and also en sures that the funds are accessible during the appropriate time. Before moving on to discuss the solutions firms prepare to meet out the liquidity risks, we will discuss the types of liquidity risk that prevails (Nikolaou 2009, 10-11). Figure 1 Source: (Fiedler 2002). There are two types of liquidity risks that would be discussed in this study, namely: a) Market Liquidity Risk, and b) Funding Liquidity Risk. The Market Liquidity Risk means that the assets cannot be sold in the market due to constraints in liquidity in the market. It can be due to widening of the offer spread, expansion of holding period, or making unambiguous liquidity reserves. The Funding Liability Risk means having risk when the liabilities cannot be met, when they are due, can be met when the price is uneconomic, or is systematic. There are different situations or causes due to when liquidity risk can be assessed. The situation when not a single buyer is available in the market to trade for an asset or assets, l eads to liquidity risks. Liquidity risk can be denoted as a financial risk which occurs due to uncertain liquidity. Liquidity risks might arise when the credit ratings of the firm falls, or when it experiences a sudden outflow of cash (Drehmann, and Nikolaou 2009, 4-5). The recent disintegration of several huge financial institutions reveals the critical nature of the liquidity risks and also depicts the critical role that it plays for the regulators, globally. The Bank of International Settlements (BIS) was among the first to adopt the comprehensive regime of testing liquidity risk and protecting the institutional stakeholders. The Financial Service Authorities (FSA) has also issued policy statement PS09/16, for strengthening the liquidity standards. Liquidity risk can be regarded as both eccentric as well as systematic. It plays a crucial role for the banking entities and the other industries too. Liquidity risks may vary between assets, liability and time. It includes the institu tional stakeholders like the creditors, debtors, owners, etc (Oracle Financial Services 2009, 2-4). Risk Measurement The recent fluctuations in the financial market included the payment system and several banking processes which are directly related to short-term forecasting. The control system should be such so that it can measure the liquidity risks and the performance with relation to the models utilized for market and credit risks.