Explain the liquidy risk and asset tranformation risk.

Expert Solution

Ans Liquidity Risk - Liquidity refers to the company ability to meet short term expenses or financial obligations. Liquidity is nothing but those assets which can be converted into cash very quickly to meet the companies day to day expenses for business operations. Examples of liquid assets include cash, savings account, cash equivalents like treasury bills and commercial papers, etc. Liquidity Risk arises when a company is not able to meet its financial obligation or has the low capability to met its day to day expenses to run its business operations.

The best tool to find whether the company's liquid potential is strong enough or not is by the liquid ratio. it measures the company liquidity risk. If the ratio is too low then the liquidity risk is high for that company. Reasons for high liquidity risk can be Lack of buyers in the market for the company, the company is not holding the current assets and also inefficient in managing current assets regularly, Taking too much time in finding the buyers eg- In real estate business, unexpected high amount of cash outflow. These risks are higher in emerging markets. Liquidity risks bring loss of capital or income in the process of liquidation.

Asset transformation risk- asset transformation is nothing but it is a process where a new asset is created like loans from old assets like deposits through various ways like small denomination, immediately available and converting bank deposits into a loan. This Asset transformation usually is done by the financial institution where they buy assets or securities and issue them as a source of funds. These Securities involves certain characteristics for certain securities like maturity and liquidity. Example of a financial institution which involves assets transformation is a bank.

When these financial institutions perform assets transformation certain risk is attached to them. This risk is called asset transformation risk. for example, if a bank gives a loan to its client then there are certain risks like default risk. this risk occurs when the bank did not the required amount at the maturity of the loan. perhaps the most important risk which a bank is exposed because of asset transformation is interest rate risk. Interest rate risk arises when there is a mismatch between the maturity of its assets and liability of the financial institutions. Interest rate risk happens because of the rates and reinvestment features of long-term income of financial asset react to differently when there is a change in interest rates of the market, the rates and the expense of interest rates is related to the short term deposit.

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