What does liquidity risk refer to in finance?

Liquidity risk specifically pertains to the possibility that an entity will be unable to fulfill its short-term financial obligations due to an inability to convert assets into cash quickly enough without incurring a significant loss. This situation often arises during financial distress or market disruptions when assets may not be readily saleable at their fair value.

In financial markets, liquidity is essential because it enables participants to buy and sell assets without causing substantial price changes. When liquidity is low, it can lead to challenges for both individuals and businesses to pay off debts or meet other immediate financial requirements, which can further exacerbate financial difficulties.

The other options address different types of risks. Asset value fluctuation references market risk and the variability in investment prices over time. Losing investment capital relates to credit risk or market risk, where the value of an investment declines, and the risk of fraud pertains to integrity issues within transactions rather than liquidity. Thus, the focus of liquidity risk is specifically on the ability to meet short-term obligations, making it the most appropriate answer.