Liquidity Risk

A client asks what is meant by capital risk. The best description is the possibility that:

1. A.Interest rates rise and the market value of a bond falls before it matures.Wrong. That is interest rate risk, which describes price movement rather than the permanent loss of principal.
2. B.Income from an investment fails to keep pace with the general rate of inflation.Wrong. That is purchasing power risk, and it concerns what the return buys rather than whether it exists.
3. C.A security cannot be sold quickly without the seller accepting a lower price.Wrong. That is liquidity risk, which is about marketability rather than about the money disappearing.
4. D.The entire amount invested may be lost and never recovered at all.Correct. Capital risk is the exposure of invested principal to being lost outright.

Why: Capital risk is the plain possibility that money put into a security does not come back. It is present in any investment not backed by an unconditional promise from a creditworthy obligor, and it is why equity holders sit last in liquidation. The other risks named describe how a return may disappoint rather than whether the principal survives at all. An investor can face several of these at once, which is why they are treated as distinct categories rather than as degrees of one thing.

An investor needs cash and tries to sell a bond that rarely trades. The only bids available sit well below the last reported price. This exposure is best described as:

1. A.Liquidity risk, the risk of being unable to sell promptly at a fair price.Correct. Thin trading forces a seller to accept a discount, which is precisely what marketability risk describes.
2. B.Credit risk, the risk that the issuer fails to make its scheduled payments.Wrong. Nothing in the facts suggests the issuer has missed a payment or is likely to miss one.
3. C.Market risk, the risk that the entire bond market declines in value together.Wrong. A broad market decline would move prices for everyone, while the problem here is finding any buyer at all.
4. D.Reinvestment risk, the risk of having to put proceeds back to work at a lower rate.Wrong. That risk arises after a sale or a maturity, when the proceeds have to be put back to work.

Why: Liquidity risk is the risk that a holder cannot convert a position into cash quickly without surrendering value. It is driven by how many buyers and sellers are active in that particular instrument, which is why thinly traded municipal issues, private placements and limited partnership interests carry so much of it. The discount the seller must accept reflects that scarcity rather than any judgment about the issuer's finances. An investor who may need money at short notice should keep enough of the portfolio in instruments with deep and continuous markets.

A client owns forty small municipal bond issues from forty separate issuers. She needs cash quickly and finds few buyers for any of them. Which statement is correct?

1. A.Her exposure to default is high, which is precisely why buyers are scarce today.Wrong. Nothing suggests these issuers are weak, and thin markets in small issues exist regardless of credit quality.
2. B.Offering all forty positions at once should attract more buyers than offering one.Wrong. Offering more thinly traded paper at once tends to widen the discount rather than narrow it.
3. C.Liquidity improves with the number of holdings, so she is better placed than she thinks.Wrong. Marketability is a property of each individual issue, and owning many illiquid issues creates no market.
4. D.Diversification reduced her default exposure but created no marketability at all.Correct. Spreading across issuers addresses who might default, not whether anyone will buy on the day she sells.

Why: Diversification and liquidity answer different questions. Spreading across forty issuers means no single default can be decisive, which is a real benefit. It says nothing about whether an active market exists in any individual issue, and small municipal issues typically trade rarely. A client who may need cash at short notice has to hold instruments with deep markets, such as Treasury securities or a money market fund, rather than a longer list of illiquid ones.