LOS k: Explain liquidity risk and why it might be important to investors even if they expect to hold a security to the maturity date.

Q1. Which of the following assets is the least liquid?

A)   Foreign exchange futures contract.

B)   On-the-run Treasury security.

C)   Limited Partnership.

Q2. Which of the following statements does NOT describe a characteristic of an illiquid asset or market?

A)   Small trading volumes.

B)   Wide bid-ask spreads.

C)   Large block trades that do not materially affect prices.

Q3. Which of the following statements regarding liquidity risk is FALSE?

A)   Emerging markets typically have more liquidity risk than established markets.

B)   Liquidity risk is not important to an investor who intends to hold a security until maturity.

C)   The bid-ask spread is one measurement of liquidity risk.

Q4. Which of the following investors is least likely to have liquidity risk concerns? A:

A)   corporate bond investor who intends to hold securities until maturity.

B)   trader who invests exclusively in Treasury bonds.

C)   financial institution heavily involved in the repurchase market.

LOS k: Explain liquidity risk and why it might be important to investors even if they expect to hold a security to the maturity date.fficeffice" />

Q1. Which of the following assets is the least liquid?

A)   Foreign exchange futures contract.

B)   On-the-run Treasury security.

C)   Limited Partnership.

Correct answer is C)        

All other choices are considered highly liquid assets. On-the-run Treasuries are recently issued and are often more liquid than older issues.

Q2. Which of the following statements does NOT describe a characteristic of an illiquid asset or market?

A)   Small trading volumes.

B)   Wide bid-ask spreads.

C)   Large block trades that do not materially affect prices.

Correct answer is C)        

In a liquid market with large trading volumes, large block trades should not affect prices. The other choices are characteristics of illiquid markets or assets.

Q3. Which of the following statements regarding liquidity risk is FALSE?

A)   Emerging markets typically have more liquidity risk than established markets.

B)   Liquidity risk is not important to an investor who intends to hold a security until maturity.

C)   The bid-ask spread is one measurement of liquidity risk.

Correct answer is B)

Even if an investor intends to hold securities to maturity, liquidity risk impacts portfolios when marking to market and through changes in investor tastes and preferences over time. For example, liquidity is important to institutional investors that must determine market values for net asset values (NAVs) and to dealers in the repurchase market for collateral valuation.

A narrow bid-ask spread indicates a liquid asset, while a wide bid-ask spread indicates an illiquid asset. For example, the spreads on recently issued Treasury securities are often only a few basis points. Emerging markets are usually less liquid than established markets, one reason being the small trading volumes.

Q4. Which of the following investors is least likely to have liquidity risk concerns? A:

A)   corporate bond investor who intends to hold securities until maturity.

B)   trader who invests exclusively in Treasury bonds.

C)   financial institution heavily involved in the repurchase market.

Correct answer is B)

Treasury securities are the most liquid of the investments mentioned.

The repurchase market is short term in nature and the collateral is marked-to-market daily. Thus, the need to quickly convert securities to cash (and at approximately market value) is very important. Emerging markets are usually less liquid than established markets, one reason being the small trading volumes. Even if an investor intends to hold the security to maturity, liquidity risk impacts portfolios when marking to market and through changes in investor tastes and preferences over time. For example, liquidity is important to institutional investors that must determine market values for net asset values (NAVs).

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