Imagine you are drafting an equity research note on a mid-cap company listed on the NSE.
Your valuation model indicates a significant upside based on strong fundamentals, but your supervisor asks a critical question: ‘If our institutional client needs to exit this position in a downturn, what is the cost of liquidity?’ This forces you to look beyond simple trading volume and consider the multi-dimensional nature of liquidity risk, which is the risk that an asset cannot be traded quickly enough in the market to prevent a loss or make the required profit.
Liquidity risk manifests in two primary forms: asset liquidity risk and funding liquidity risk. Asset liquidity risk—the more common focus for a research analyst—refers to the inability to sell an asset at its fair market price due to a lack of buyers. This often leads to a ’liquidity discount,’ where a large sell order causes the stock price to plummet, effectively eroding the gains forecasted in your DCF or relative valuation model.
If you fail to factor this into your risk-adjusted return expectations, you are providing an incomplete picture to your client.
To manage this, professional analysts look at bid-ask spreads and market impact costs rather than just the average daily turnover. A stock with high daily volumes might still be illiquid if it is tightly held by promoters with very little free float, as a large block trade would significantly move the price. For instance, in the Indian markets, small-cap stocks often exhibit a ‘gapping’ behavior where the bid-ask spread widens dramatically during periods of market stress, rendering the ’last traded price’ an unreliable metric for exit valuation.
Incorporating liquidity risk into your judgment requires a holistic view of the market ecosystem. If you are recommending an asset that is prone to liquidity dry-ups, you must explicitly inform the client that the time horizon for their exit might be longer than expected. By quantifying the potential impact cost, you move from being a theoretical modeller to a practical strategist who understands that the price on the screen is not always the price at which a trade can be executed.
Nuance
Check Your Understanding
An analyst is evaluating a small-cap firm with low free float. Even though the stock shows daily trading volume, the analyst remains concerned about liquidity risk. Which factor best explains why this concern is valid?
Which of the following describes the ‘bid-ask spread’ as a component of liquidity risk?
This is a companion read for Section 12.3 — Risks in Investments from PASS Research Analyst Certification Examination by Akhilesh Gururani, available on Amazon Kindle.
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