Question

1. Which of the following statements regarding liquidity risk in correct? Explain why
   1. Asset liquidity risk arises when a financial institution cannot meet payment obligations.
   2. Flight to quality is usually reflected in a decrease in the yield spread between corporate and government debt issuances.
   3. Yield spread between on-the-run and off-the-run securities mainly captures the liquidity premium.
   4. Funding liquidity risk can be managed by setting limits on certain asset markets or products and by means of diversification.

Answer 1

A.) Incorrect.
Asset liquidity risk is the risk of not finding the buyers for the asset to be sold at a good price in market. Such risk arises when there is less demand for the asset being sold. Less demand makes it difficult for the asset seller to convert the asset into cash.

B) Correct
Flight to quality in a corporate debt can be seen in the decrease of spreads between the corporate debt and government debt.
For example- Government bonds in India have a yeild of 5% whereas, a company issuing debt would issue a bond at a yeild of 8%. The inverstors here find the company to be riskier than the Indian government and therefore require a premium of 8%-5%=3%. We can also say that the company's bonds are trading at a spread of 3%.

C.) Correct
On the run bonds are the most recently issued bonds whereas off the run bonds are securities issued a good time ago. On the run securities usually have higher liquidity than similar off the run securities, which is why they are traded with a premium compared to similar off the run securities. Higher prices means lower yields for on the run securities compared to off the run securities.

D) Incorrect
Funding liquidity risk is the risk a corporation faces when it is unable to cater it's short term obligations to pay it's creditors. Reason for usually not having enough cash or marketable securities to pay off the creditors.
It is more concerned to the corporation's operating cash flows rather than it's trading activities in the market. Which is why putting limits on certain asset markets or diversification will not be useful.