Liquidity risk is the inability to sufficiently capitalize an asset within a short period of time.(2) Since illiquid assets typically don't sell frequently, fair valuation of those assets can present a unique challenge to investors in art, real estate and corporations not listed on public exchanges.
Liquidity risk can affect the value of an investment in a number of ways, however sometimes the conditions of sale and market itself can also be relevant enough to significantly influence the value of an illiquid investment. Being aware of how liquidity risk affects investment value can help with investment risk management.
• Pricing information
According to Compliance Week, a corporate information provider, illiquid assets can affect the value of an investment because of lack of valuation data.(3) For example, a private company that is for sale but does not disclose all its financial data would make quantitative valuation of book value more difficult. In cases of good will assets, where a client base is considered valuable, assessing how much that client base is worth may also be a matter of qualitative assessment rather than quantitative data.
• Lower demand
When an investment asset is illiquid, the demand may go down while the asking price may remain high. Moreover, the high price of the asset may exclude a large percentage of the market from buying it thereby making the asset more illiquid. This makes valuation of the asset more subject to negotiation, and seller motivation than market pricing.
• Market conditions
Another way liquidity risk can affect the value of an investment is through changes in market and economic conditions while the illiquid asset is on the market. For example, a large expensive apartment building may be valued higher when it is put on the market during economic conditions of low-interest rate, and during the peak of a business cycle. However, if the building does not sell relatively quickly, those conditions can change, also affecting the value of the building.
• Asset structure
In the cases of corporations, too few liquid assets in a business can make it less attractive to investors and affect its value. For example, a service corporation that relies heavily on the demand for specialized consulting may not only be difficult to value based on the quality and demand of its consulting know how, but also because of the illiquid nature of such a firms assets. In such case converting the company into tangible assets may be difficult and present a liquidity risk.
• Debt risk
Liquidity risk can also lead to debt risk because a corporate structured investment may not be able to pay its debts via its own lack of liquid investments.(1) In other words, because a company has a capital asset structure heavily waited toward equipment that is used in daily business operations, that company may not only lose revenue from conversion of these assets to liquid assets. This company may also not have adequate cash flow or credit to maintain a cash conversion cycle i.e. billings and payments which can also increase liquidity risk.
Liquidity risk can affect the value of an investment in a number of ways, however sometimes the conditions of sale and market itself can also be relevant enough to significantly influence the value of an illiquid investment. Being aware of how liquidity risk affects investment value can help with investment risk management.
• Pricing information
According to Compliance Week, a corporate information provider, illiquid assets can affect the value of an investment because of lack of valuation data.(3) For example, a private company that is for sale but does not disclose all its financial data would make quantitative valuation of book value more difficult. In cases of good will assets, where a client base is considered valuable, assessing how much that client base is worth may also be a matter of qualitative assessment rather than quantitative data.
• Lower demand
When an investment asset is illiquid, the demand may go down while the asking price may remain high. Moreover, the high price of the asset may exclude a large percentage of the market from buying it thereby making the asset more illiquid. This makes valuation of the asset more subject to negotiation, and seller motivation than market pricing.
• Market conditions
Another way liquidity risk can affect the value of an investment is through changes in market and economic conditions while the illiquid asset is on the market. For example, a large expensive apartment building may be valued higher when it is put on the market during economic conditions of low-interest rate, and during the peak of a business cycle. However, if the building does not sell relatively quickly, those conditions can change, also affecting the value of the building.
• Asset structure
In the cases of corporations, too few liquid assets in a business can make it less attractive to investors and affect its value. For example, a service corporation that relies heavily on the demand for specialized consulting may not only be difficult to value based on the quality and demand of its consulting know how, but also because of the illiquid nature of such a firms assets. In such case converting the company into tangible assets may be difficult and present a liquidity risk.
• Debt risk
Liquidity risk can also lead to debt risk because a corporate structured investment may not be able to pay its debts via its own lack of liquid investments.(1) In other words, because a company has a capital asset structure heavily waited toward equipment that is used in daily business operations, that company may not only lose revenue from conversion of these assets to liquid assets. This company may also not have adequate cash flow or credit to maintain a cash conversion cycle i.e. billings and payments which can also increase liquidity risk.
Sources:
1. http://bit.ly/aV7oyN (FFIC)
2. http://bit.ly/aN6pYh (FINRA)
3. http://bit.ly/c5gmRr (Compliance Week)
:.
0 comments:
Post a Comment