Liquidity Risk and the Rate of Interest - Research Paper Example

The paper "Liquidity Risk and the Rate of Interest" is a great example of a finance and accounting research paper. Liquidity risk takes place in a financial institution due to the fact that there are no adequate funds or equivalent cash to meet the needs of both depositors and borrowers. Several studies have shown that stocks and bonds having lower liquid have lower prices and command higher expected proceeds. Nonetheless, comparatively little is known regarding the implication of liquidity risk to the interest rate. In macroeconomics, the liquidity effect is the drop of nominal interest rates after an exogenous constant rise within narrow measures of the supply of funds. An exogenous constant increase of funds increases inflation and therefore increases interest rates. This paper analyses the factors that influence liquidity risk and the rate of interest in relation to UAE banks and how the situation can be put under control.

• Background information
• Liquidity risk

Liquidity risk refers to the risk that certain security or asset cannot be traded as fast as it is supposed to be within the market to prevent any loss or to make the needed profit. To be specific, liquidity risk is the uncertainty needed by a financial institution to get big amounts of money to balance the withdrawals from the depositors or any other liability petitioners. During the usual economic activity, depository financial institutions are able to meet cash withdrawals through having deposits and borrowing money within the short-term money markets. On the other hand, during liquidity crises, financial institutions might need to sell assets at major losses for them to get cash fast (Mishkin, 2009).

• Interest rate

Interest rate refers to the rate whereby interest is paid by a borrower for using the money that the borrower borrows from the lender. For instance, a small business organization borrows capital in form of money from a bank to purchase assets for their businesses, and in return, the lender gets interested at a fixed interest rate for adjourning the utilization of finances and instead of lending the funds to the borrower. Normally, interest rates are expressed as a proportion of the prime for a period of one year. Interest rates marks are also an important mechanism of monetary policy and are considered when handling variables such as investment, inflation as well as unemployment (Mishkin, 2009).