Which of the following statements regarding liquidity risk is correct?
a) Asset liquidity risk arises when a financial institution cannot meet payment obligations.
b) Flight to quality is usually reflected in a decrease in the yield spread between corporate and government issues.
c) Yield spread between on-the-run and off-the-run securities mainly captures the liquidity premium, and not the market and credit risk premium.
d) Funding liquidity risk can be managed by setting limits on certain asset markets or products and by means of diversification.
The type of risk that an organization encounters because of the inability to satisfy the short-term monetary requirements is known as liquidity risk. It also means the organization is not capable enough to convert the assets into cash and its equivalent forms.
Answer and Explanation:
The correct option is c) Yield spread between on-the-run and off-the-run securities mainly captures the liquidity premium, and not the market and credit risk premium.
On-the-run bonds are issued frequently, whereas off-the-run bonds are issued in some interval of time. On-the-run securities are more liquid as compared to off the run. As these securities are similar in the credit and market risks, hence only measures the liquidity premium.
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from Finance 305: Risk ManagementChapter 1 / Lesson 4