What is the relationship between liquidity and risk?

The relationship between liquidity and risk is significant, and choosing the correct answer highlights an essential aspect of financial markets. Higher liquidity reduces risk because it allows for more efficient buying and selling of assets with minimal impact on their prices. When a market is highly liquid, there are numerous buyers and sellers, enabling participants to enter and exit positions easily without significant price fluctuations. This ease of trading acts as a buffer against volatility and allows investors to respond quickly to market changes, thereby lowering the likelihood of experiencing major losses.

In contrast, lower liquidity often leads to higher risk. In less liquid markets, transactions can cause significant price changes, increasing the potential for losses when buying or selling assets. When investors cannot quickly liquidate their positions, they may have to sell at unfavorable prices, which exacerbates risk.

Understanding liquidity's role in risk management is crucial for investors as it underlines the importance of selecting investments within markets where their assets can be traded readily, thereby mitigating associated risks.