Liquidity Risk Investopedia

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Amaranth Advisors lost roughly $6bn in the natural gas futures market in September 2006. Amaranth had taken a concentrated, leveraged, and undiversified position in its natural gas strategy. Amaranth’s positions were staggeringly large, representing around 10% of the global market in natural gas futures. Chincarini notes that firms need to manage liquidity risk explicitly. The inability to sell a futures contract at or near the latest quoted price is related to one’s concentration in the security. In Amaranth’s case, the concentration was far too high and there were no natural counterparties when they needed to unwind the positions. Chincarini (2006) argues that part of the loss Amaranth incurred was due to asset illiquidity. Regression analysis on the 3 week return on natural gas future contracts from August 31, 2006 to September 21, 2006 against the excess open interest suggested that contracts whose open interest was much higher on August 31, 2006 than the historical normalized value, experienced larger negative returns.

Investors, managers and creditors use liquidity measurement ratios when deciding the level of liquidity risk within an organization. They often compare short-term liabilities and liquid assets listed on the company’s financial statements. If a business has too much liquidity risk, it must sell assets, bring in additional revenue or find another way to reduce the discrepancy between available cash and debt obligations.

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