Liquidity risk in financial markets

Liquidity risk is a financial risk that for a certain period of time a given financial assetsecurity or commodity cannot be traded quickly enough in the market without impacting the market price. Market liquidity — An asset cannot be sold due to lack of liquidity in the market — essentially a sub-set of market 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.

Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade. Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other.

Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution.

A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. Market and funding liquidity risks compound each other as it is difficult to sell when other investors face funding problems and it is difficult to get funding when the collateral is hard to sell.

Liquidity Risk

If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk.

Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment.

Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk. A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk example—the two payments are offsetting, so they entail credit risk but not market risk.

Another example is the Metallgesellschaft debacle. Futures contracts were used to hedge an Over-the-counter finance OTC obligation. It is debatable whether the hedge was effective from a market risk standpoint, but it was the liquidity crisis caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions. Accordingly, liquidity risk has to be managed in addition to market, credit and other risks.

Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis.

Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults. Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organization's cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis.

A general approach using scenario analysis might entail the following high-level steps:. Because balance sheets differ so significantly from one organization to the next, there is little standardization in how such analyses are implemented.

Risk-averse investors naturally require higher expected return as compensation for liquidity risk. A common method for estimating the upper bound for a security illiquidity discount is by using a Lookback option, where the premia is equal to the difference between the maximum value of a security during a restricted trading period and its value at the end of the period.

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.

Liquidity Risk

As a static measure of liquidity risk it gives no how to get money in harvest moon boy and girl psp of how the gap would change with an increase in the firm's marginal funding cost. 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 liquidity risk in financial markets 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.

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 bid price can be used. The smaller the ratio the more liquid the asset is.

This spread is composed of operational, administrative, and hang seng index futures trading costs as well as the compensation required for the possibility of trading with a more informed trader.

Hachmeister refers to market depth as the amount of an asset that can be bought and bloomberg market stock futures 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.

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 trading systems and methods + website (wiley trading) resilience can only be determined over a period of time.

Liquidity-adjusted VAR incorporates exogenous liquidity risk into Value at Risk. The ELC is the worst expected half-spread at a particular confidence level. Another adjustment, introduced in the s with a regulatory precursor to today's VAR measures, [7] 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 " Alan Greenspan discusses management of foreign exchange reserves and suggested a measure called Liquidity at risk.

A country's liquidity position under a range of possible outcomes for relevant financial variables exchange rates, commodity prices, credit spreads, etc. 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 exchange rate euro dollar december 2016 probability, such as 95 percent of the time.

If several liquidity providers are on call then if any of those providers increases liquidity risk in financial markets 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. The credit issuer should have an appropriately high credit rating to increase the chances that the resources will be there when needed. Bhaduri, Meissner and Youn discuss five derivatives created specifically for hedging liquidity risk Amaranth had a concentrated, undiversified position in its natural gas strategy.

The trader had used leverage to build a very large position. Regression analysis on the 3 week return on natural gas future contracts from August 31, to September 21, against the excess open interest suggested that contracts whose open interest was much higher on August 31, than the historical normalized value, experienced larger negative returns.

Northern Rock suffered from funding liquidity risk in September following the subprime crisis. The firm suffered from liquidity issues despite being solvent at the time, because maturing loans and deposits could not be renewed in the short-term money markets. Long-Term Capital Management LTCM was bailed out by a consortium of 14 banks in after being caught in a cash-flow crisis when economic shocks resulted in excessive mark-to-market losses and margin calls. The fund suffered from a combination of funding and asset liquidity.

Asset liquidity arose from LTCM failure to account for liquidity becoming more valuable as it did following the crisis. Since much of its balance sheet was exposed to liquidity risk premium its short positions would increase in price relative to its long positions. This was essentially a massive, unhedged exposure to a single risk factor.

In response to this, LTCM had negotiated long-term financing with margins fixed for several weeks on many of their collateralized loans. Due to an escalating liquidity spiral, LTCM could ultimately not fund its positions in spite of its numerous measures to control funding risk. From Wikipedia, the free encyclopedia.

Not to be confused with Liquidity at risk. Nationalisation of Northern Rock. Review of Financial Studies. Journal of Financial Economics. The Journal of Finance. Journal of Financial Stability. Archived from the original PDF on July 12, Theory and Practice, Second Edition". Retrieved July 2, Bank for International Settlements. Retrieved August 8, Federal Deposit Insurance Corporation. American Academy of Actuaries. Lessons from the Collapse of Amaranth Advisors L. Failure of Risk Measures or Failure of Risk Management?

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