What does liquidity risk refer to?

Liquidity risk specifically concerns the potential inability to quickly sell an asset without incurring a substantial loss. This can happen in markets with low trading volumes or when there are few buyers willing to purchase the asset at its expected value.

In such scenarios, if an investor needs to liquidate a position rapidly due to financial needs or market pressures, they may have to accept a significantly lower price than anticipated. Understanding this risk is crucial for financial decision-making, as it affects the overall strategy for asset allocation and investor confidence in the market.

The other options describe different types of financial risks. Unpredictable interest rate changes pertain to interest rate risk, while a company's balance sheet valuation directly relates to valuation risk or accounting accuracy. Foreign exchange fluctuations represent currency risk. Although these risks are essential to understand, they do not encapsulate the essence of liquidity risk, which is primarily about the market's ability to facilitate the quick sale of assets without substantial depreciation in value.