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Liquidity Risk

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Matthew Biscocho

on 9 July 2014

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Transcript of Liquidity Risk

Liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).
Liquidity Risk
Market liquidity
 – An asset cannot be sold due to lack of liquidity in the market – essentially a sub-set of market risk. This can be accounted for by:
Widening bid/offer spread
Making explicit liquidity reserves
Lengthening holding period for VaR calculations
Types of Liquidity Risk
Immediacy refers to the time needed to successfully trade a certain amount of an asset at a prescribed cost.
Hachmeister identifies the fourth dimension of liquidity as the speed with which prices return to former levels after a large transaction. Unlike the other measures resilience can only be determined over a period of time.

Measures of Asset Liquidity
Funding liquidity
 – Risk that liabilities:
Cannot be met when they fall due
Can only be met at an uneconomic price
Can be name-specific or systemic

Types of Liquidity Risk
Liquidity Risk Management
Biscocho, Matthew
Balotoc, Frances Aila
Manaig, Jane Aira
Rodillo, Ryan Robert

Causes of Liquidity Risk
Measure of Asset Liquidity
Market depth
Hachmeister refers to market depth as the amount of an asset that can be bought and sold at various bid-ask spreads. Slippage is related to the concept of market depth. Knight and Satchell mention a flow trader needs to consider the effect of executing a large order on the market and to adjust the bid-ask spread accordingly. They calculate the liquidity cost as the difference of the execution price and the initial execution price.

Diversification of liquidity providers
If several liquidity providers are on call then if any of those providers increases its costs of supplying liquidity, the impact of this is reduced. The American Academy of Actuaries wrote "While a company is in good financial shape, it may wish to establish durable, ever-green (i.e., always available) liquidity lines of credit. The credit issuer should have an appropriately high credit rating to increase the chances that the resources will be there when needed."

Managing Liquidity Risk
Risk-averse investors naturally require higher expected return as compensation for liquidity risk. The liquidity-adjusted CAPM pricing model therefore states that, the higher an asset’s market-liquidity risk, the higher its required return.

Pricing of Liquidity Risk
Bid-offer spread
The bid-offer spread is used by market participants as an asset liquidity measure. To compare different products the ratio of the spread to the product's mid price can be used. The smaller the ratio the more liquid the asset is.
This spread is composed of operational, administrative, and processing costs as well as the compensation required for the possibility of trading with a more informed trader.

Measurs of Asset Liquidity
Liquidity-adjusted value at risk
Liquidity-adjusted VAR incorporates exogenous liquidity risk into Value at Risk. It can be defined at VAR + ELC (Exogenous Liquidity Cost). The ELC is the worst expected half-spread at a particular confidence level.
Another adjustment, introduced in the 1970s with a regulatory precursor to today's VAR measures, is to consider VAR over the period of time needed to liquidate the portfolio. VAR can be calculated over this time period. The BIS mentions "... a number of institutions are exploring the use of liquidity adjusted-VAR, in which the holding periods in the risk assessment are adjusted by the length of time required to unwind positions." 

Managing Liquidity Risk
Liquidity gap
Culp defines the liquidity gap as the net liquid assets of a firm. The excess value of the firm's liquid assets over its volatile liabilities. A company with a negative liquidity gap should focus on their cash balances and possible unexpected changes in their values.
As a static measure of liquidity risk it gives no indication of how the gap would change with an increase in the firm's marginal funding cost.

Measures of Liquidity Risk
Liquidity risk elasticity
Culp denotes the change of net of assets over funded liabilities that occurs when the liquidity premium on the bank's marginal funding cost rises by a small amount as the liquidity risk elasticity. For banks this would be measured as a spread over libor, for nonfinancials the LRE would be measured as a spread over commercial paper rates.
Problems with the use of liquidity risk elasticity are that it assumes parallel changes in funding spread across all maturities and that it is only accurate for small changes in funding spreads.
Measures of Liquidity Risk
Liquidity at risk
Alan Greenspan (1999) discusses management of foreign exchange reserves. The Liquidity at risk measure is suggested. A country's liquidity position under a range of possible outcomes for relevant financial variables (exchange rates, commodity prices, credit spreads, etc.) is considered. It might be possible to express a standard in terms of the probabilities of different outcomes. For example, an acceptable debt structure could have an average maturity—averaged over estimated distributions for relevant financial variables—in excess of a certain limit. In addition, countries could be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowing for one year with a certain ex ante probability, such as 95 percent of the time.

Managing Liquidity Risk
Scenario analysis-based contingency plans
The FDIC discuss liquidity risk management and write "Contingency funding plans should incorporate events that could rapidly affect an institution’s liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty.“ Greenspan's liquidity at risk concept is an example of scenario based liquidity risk management.

Managing Liquidity Risk
Bhaduri, Meissner and Youn discuss five derivatives created specifically for hedging liquidity risk:
Withdrawal option: A put of the illiquid underlying at the market price.
Bermudan-style return put option: Right to put the option at a specified strike.
Return swap: Swap the underlying's return for LIBOR paid periodicially.
Return swaption: Option to enter into the return swap.
Liquidity option: "Knock-in" barrier option, where the barrier is a liquidity metric.

Managing Liquidity Risk
Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade for that asset.
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