Liquidity risk

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Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.

Financial risk Any of various types of risk associated with financing

Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.

A financial asset is a non-physical asset whose value is derived from a contractual claim, such as bank deposits, bonds, and stocks. Financial assets are usually more liquid than other tangible assets, such as commodities or real estate, and may be traded on financial markets.

Security (finance) tradable financial asset

A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some jurisdictions the term specifically excludes financial instruments other than equities and fixed income instruments. In some jurisdictions it includes some instruments that are close to equities and fixed income, e.g., equity warrants. In some countries and languages the term "security" is commonly used in day-to-day parlance to mean any form of financial instrument, even though the underlying legal and regulatory regime may not have such a broad definition.

Contents

Types

Market liquidity – An asset cannot be sold due to lack of liquidity in the market – essentially a sub-set of market risk. [1] This can be accounted for by:

Value at risk risk measure on a specific portfolio of financial assets.

Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose, given normal market conditions, in a set time period such as a day. VaR is typically used by firms and regulators in the financial industry to gauge the amount of assets needed to cover possible losses.

Funding liquidity – Risk that liabilities:

Causes

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.

Asset economic resource, from which future economic benefits are expected

In financial accounting, an asset is any resource owned by the business. Anything tangible or intangible that can be owned or controlled to produce value and that is held by a company to produce positive economic value is an asset. Simply stated, assets represent value of ownership that can be converted into cash. The balance sheet of a firm records the monetary value of the assets owned by that firm. It covers money and other valuables belonging to an individual or to a business.

Financial market generic term for all markets in which trading takes place with capital

A financial market is a market in which people trade financial securities and derivatives such as futures and options at low transaction costs. Securities include stocks and bonds, and precious metals.

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. [2] This is why liquidity risk is usually found to be higher in emerging markets or low-volume markets.

Party gathering of invited guests

A party is a gathering of people who have been invited by a host for the purposes of socializing, conversation, recreation, or as part of a festival or other commemoration of a special occasion. A party will typically feature food and beverages, and often music and dancing or other forms of entertainment. In many Western countries, parties for teens and adults are associated with drinking alcohol such as beer, wine, or distilled spirits.

Market (economics) Mechanisms whereby supply and demand confront each other and deals are made, involving places, processes and institutions in which exchanges occur.

A market is one of the many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers. It can be said that a market is the process by which the prices of goods and services are established. Markets facilitate trade and enable the distribution and resource allocation in a society. Markets allow any trade-able item to be evaluated and priced. A market emerges more or less spontaneously or may be constructed deliberately by human interaction in order to enable the exchange of rights of services and goods. Markets generally supplant gift economies and are often held in place through rules and customs, such as a booth fee, competitive pricing, and source of goods for sale.

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 counter parties 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. [1] Liquidity risk also tends to compound other risks. 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 counter party 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 1993 Metallgesell schaft 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 Metallgesell schaft 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 counter party 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.

Regulators are primarily concerned about systemic implications of liquidity risk.

Pricing

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. [3]

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. [4] When the method is extended for corporate debt it is shown that liquidity risk increases with a bond credit risk. [5]

Measures of 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.

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 asset liquidity

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 bid 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.

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.

Immediacy

Immediacy refers to the time needed to successfully trade a certain amount of an asset at a prescribed cost.

Resilience

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, i.e., resilience is the capacity to recover.

Management

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. [6]

Another adjustment, introduced in the 1970s 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 "... 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." [8]

Liquidity at risk

Alan Greenspan (1999) 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.) 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. [9]

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." [10] Greenspan's liquidity at risk concept is an example of scenario based liquidity risk management.

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." [11]

Derivatives

Bhaduri, Meissner and Youn discuss five derivatives created specifically for hedging liquidity risk.:

Case studies

Amaranth Advisors LLC – 2006

Amaranth Advisors lost roughly $6bn in the natural gas futures market in September 2006. Amaranth had taken a concentrated, leveraged, and undiversified position in its natural gas strategy. Amaranth’s positions were staggeringly large, representing around 10% of the global market in natural gas futures. [12] Chincarini notes that firms need to manage liquidity risk explicitly. The inability to sell a futures contract at or near the latest quoted price is related to one’s concentration in the security. In Amaranth’s case, the concentration was far too high and there were no natural counterparties when they needed to unwind the positions. [13] Chincarini (2006) argues that part of the loss Amaranth incurred was due to asset illiquidity. Regression analysis on the 3 week return on natural gas future contracts from August 31, 2006 to September 21, 2006 against the excess open interest suggested that contracts whose open interest was much higher on August 31, 2006 than the historical normalized value, experienced larger negative returns. [14]

Northern Rock – 2007

Northern Rock suffered from funding liquidity risk in September 2007 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. [15] In response, the FSA now places greater supervisory focus on liquidity risk especially with regard to "high-impact retail firms". [16]

LTCM – 1998

Long-Term Capital Management (LTCM) was bailed out by a consortium of 14 banks in 1998 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 issues. The asset liquidity issue arose from LTCM's 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. [17] LTCM had been aware of funding liquidity risk. Indeed, they estimated that in times of severe stress, cuts on AAA-rated commercial mortgages would increase from 2% to 10%, and similarly for other securitiles. 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. [1]

Related Research Articles

In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the opportunity to instantaneously buy something for a low price and sell it for a higher price.

Derivative (finance) financial instrument whose value is based on one or more underlying assets

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying." Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the New York Stock Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges. Derivatives are one of the three main categories of financial instruments, the other two being stocks and debt. The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales, who made a profit in the exchange. Bucket shops, outlawed a century ago, are a more recent historical example.

Long-Term Capital Management L.P. (LTCM) was a hedge fund management firm based in Greenwich, Connecticut that used absolute-return trading strategies combined with high financial leverage. LTCM was founded in 1994 by John W. Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Members of LTCM's board of directors included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a "new method to determine the value of derivatives".

Market liquidity markets feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the assets price

In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity is about how big the trade-off is between the speed of the sale and the price it can be sold for. In a liquid market, the trade-off is mild: selling quickly will not reduce the price much. In a relatively illiquid market, selling it quickly will require cutting its price by some amount.

Futures contract standardized legal agreement to buy or sell something (usually a commodity or financial instrument) at a predetermined price (“forward price”) at a specified time (“delivery date”) in the future

In finance, a futures contract is a standardized forward contract, a legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price the parties agree to buy and sell the asset for is known as the forward price. The specified time in the future—which is when delivery and payment occur—is known as the delivery date. Because it is a function of an underlying asset, a futures contract is a derivative product.

Futures exchange central financial exchange where people can trade standardized futures contracts

A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of contracts fall into the category of derivatives. The opposite of the futures market is the spots market, where trades will occur immediately after a transaction agreement has been made, rather than at a predetermined time in the future. Futures instruments are priced according to the movement of the underlying asset. The aforementioned category is named "derivatives" because the value of these instruments are derived from another asset class.

A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.

Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.

In finance, a contract for difference (CFD) is a contract between two parties, typically described as "buyer" and "seller", stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time.

Prime brokerage is the generic name for a bundled package of services offered by investment banks, wealth management firms, and securities dealers to hedge funds which need the ability to borrow securities and cash in order to be able to invest on a netted basis and achieve an absolute return. The prime broker provides a centralized securities clearing facility for the hedge fund so the hedge fund's collateral requirements are netted across all deals handled by the prime broker. These two features are advantageous to their clients.

In finance, a currency swap is an interest rate derivative (IRD). In particular it is a linear IRD and one of the most liquid, benchmark products spanning multiple currencies simultaneously. It has pricing associations with interest rate swaps (IRSs), foreign exchange (FX) rates, and FX swaps (FXSs).

In economics, a liquidity premium is the explanation for a difference between two types of financial securities, that have all the same qualities except liquidity. It is a segment of a three-part theory that works to explain the behavior of yield curves for interest rates. The upwards-curving component of the interest yield can be explained by the liquidity premium. The reason behind this is that short term securities are less risky compared to long term rates due to the difference in maturity dates. Therefore investors expect a premium, or risk premium for investing in the risky security. Liquidity risk premiums are recommended to be used with longer term investments, where those particular investments are illiquid.

The following outline is provided as an overview of and topical guide to finance:

Treasury management includes management of an enterprise's holdings, with the ultimate goal of managing the firm's liquidity and mitigating its operational, financial and reputational risk. Treasury Management includes a firm's collections, disbursements, concentration, investment and funding activities. In larger firms, it may also include trading in bonds, currencies, financial derivatives and the associated financial risk management.

Initially pioneered by financial institutions during the 1970s as interest rates became increasingly volatile, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities.

A flight-to-quality, or flight-to-safety, is a financial market phenomenon occurring when investors sell what they perceive to be higher-risk investments and purchase safer investments, such as US treasuries or gold. This is considered a sign of fear in the marketplace, as investors seek less risk in exchange for lower profits.

In financial economics, a liquidity crisis refers to an acute shortage of liquidity. Liquidity may refer to market liquidity, funding liquidity, or accounting liquidity. Additionally, some economists define a market to be liquid if it can absorb "liquidity trades" without large changes in price. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price, deterioration in external financing conditions, reduction in the number of market participants, or simply difficulty in trading assets.

Mark-to-Model refers to the practice of pricing a position or portfolio at prices determined by financial models, in contrast to allowing the market to determine the price. Often the use of models is necessary where a market for the financial product is not available, such as with complex financial instruments. One shortcoming of Mark-to-Model is that it gives an artificial illusion of liquidity, and the actual price of the product depends on the accuracy of the financial models used to estimate the price. On the other hand it is argued that Asset managers and Custodians have a real problem valuing illiquid assets in their portfolios even though many of these assets are perfectly sound and the asset manager has no intention of selling them. Assets should be valued at mark to market prices as required by the Basel rules. However mark to market prices should not be used in isolation, but rather compared to model prices to test their validity. Models should be improved to take into account the greater amount of market data available. New methods and new data are available to help improve models and these should be used. In the end all prices start off from a model.

Convergence trade is a trading strategy consisting of two positions: buying one asset forward—i.e., for delivery in future —and selling a similar asset forward for a higher price, in the expectation that by the time the assets must be delivered, the prices will have become closer to equal, and thus one profits by the amount of convergence.

References

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  2. Duffie, Darrell; Garleanu, Nicolae; Pedersen, Lasse Heje (2005). "Over-the-Counter Markets". Econometrica. 73 (6): 1815–47. doi:10.1111/j.1468-0262.2005.00639.x.
  3. Acharya, V; Pedersen, L (2005). "Asset pricing with liquidity risk". Journal of Financial Economics. 77 (2): 375–410. doi:10.1016/j.jfineco.2004.06.007.
  4. Longstaff, Francis A. (1995). "How Much Can Marketability Affect Security Values?". The Journal of Finance. 50 (5): 1767–74. doi:10.1111/j.1540-6261.1995.tb05197.x.
  5. Abudy, Menachem Meni; Raviv, Alon (2016). "How much can illiquidity affect corporate debt yield spread?". Journal of Financial Stability. 25: 58–69. doi:10.1016/j.jfs.2016.06.011.
  6. Arnaud Bervas (2006). "Market Liquidity and its incorporation into Risk Management" (PDF). Financial Stability Review. 8: 63–79. Archived from the original (PDF) on July 12, 2012.
  7. Glyn A. Holton (2013). "Value-at-Risk: Theory and Practice, Second Edition" . Retrieved July 2, 2013.
  8. "Final Report of the Multidisciplinary Working Group on Enhanced Disclosure". Bank for International Settlements. April 2001. Retrieved August 8, 2012.
  9. "Mr Greenspan discusses recent trends in the management of foreign exchange reserves" (PDF). Bank for International Settlements. April 29, 1999. Retrieved August 8, 2012.
  10. "Liquidity Risk Management" (PDF). Federal Deposit Insurance Corporation. 2008. Retrieved August 8, 2012.
  11. "Report of the Life Liquidity Work Group of the American Academy of Actuaries to the NAIC's Life Liquidity Working Group" (PDF). Boston, MA: American Academy of Actuaries. December 2, 2000. Retrieved August 8, 2012.
  12. Satyajit Das (January 26, 2007). "The More Things Change... Amaranth" . Retrieved August 8, 2012.
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  14. Chincarini, Ludwig B. (2007). "The Amaranth Debacle: Failure of Risk Measures or Failure of Risk Management?". doi:10.2139/ssrn.952607.
  15. Hyun Song Shin (August 2008). "Reflections on Modern Bank Runs: A Case Study of Northern Rock" (PDF). Retrieved August 9, 2012.
  16. "FSA moves to enhance supervision in wake of Northern Rock". Financial Services Authority. March 26, 2008. Retrieved August 9, 2012.
  17. Sungard Ambit. "Long-Term Capital Management Case Study". ERisk. Archived from the original on 2011-07-18.

Further reading