An investigation was carried out to explore the morphology and mechanical properties of diglycidyl ether of bisphenol A epoxy resin (DGEBA) with liquid natural rubber possessing hydroxyl functionality (HLNR). Though modification of epoxies by synthetic rubber has been extensively studied not much attention has been paid to liquid natural rubber. Photo depolymerisation of natural rubber enables us to synthesise low molecular weight oligomers by varying the experimental parameters. Epoxy resin was cured using nadic methyl anhydride as hardener in presence of N,N-dimethyl benzyl amine accelerator. Hydroxylated natural rubber of different concentrations is used as modifier for epoxy resin. The addition of such chemically modified liquid rubber to an anhydride hardener-epoxy resin mixture has given rise to the formation of a two-phase microstructure in the cured systems, consisting of spherical particles of liquid natural rubber strongly bonded to the surrounding matrix, there by providing the required mechanism for toughness enhancement. Subinclusions of epoxy resin were present in the elastomer domains as secondary particles (particle in particle morphology) as evidenced from the SEM (scanning electron micrograph) photomicrographs. The origin of the so-called secondary phase separation is due to the combined effect of hydrodynamics, viscoelastic effects of rubber phase, diffusion, surface tension, polymerisation reaction and phase separation. In a dynamic asymmetric system, the diffusion of the fast dynamic phase is prevented by the slow dynamic phase, and hence the growth of fast dynamic phase gets retarded due to the slow dynamic phase. In the case of low viscosity blends the growth of fast dynamic phase turns fast and hence diffusion of fast dynamic phase cannot follow geometrical growth and cannot establish local concentration equilibrium and hence double phase separation takes place. The double phase separation is responsible for the enhanced impact and toughness behaviour of the blends. The mechanical behaviour of the liquid rubber-modified epoxy resin was evaluated in terms of tensile and flexural properties.