Liquidity is a term that's used to refer to how easily an asset or security can be bought or sold in the market. 澳洲幸运5官方开奖结果体彩网:Liquidity risk was not on everyone's radar before the global financial crisis (GFC). Financial models routinely omitted liquidity risk. The GFC prompted a renewal to understand liquidity risk, however.

There was a consensus that the crisis included a run on the non-depository, shadow banking system: providers of short-term financing, notably in the repo market, systematically withdrew liquidity. They did so indirectly but undeniably by increasing collateral haircuts. All major 澳洲幸运5官方开奖结果体彩网:financial institutions and governments have become acutely aware that liquidity withdrawal can be a nasty accomplice in transmitting shocks through the system or even exacerbating 澳洲幸运5官方开奖结果体彩网:contagion.

What Is Liquidity Risk?

Liquidity describes how quickly something can be converted to cash. There are two different types of liquidity risk. One is funding liquidity or 澳洲幸运5官方开奖结果体彩网:cash flow risk. The other is market liquidity risk♏, also referred to as asset/prod💫uct risk.

Funding Liquidity Risk

Funding or cash flow liquidity risk is the chief concern of a corporate treasurer who asks whether the firm can fund its liabilities. A classic indicator of funding liquidity risk is the 澳洲幸运5官方开奖结果体彩网:current ratio, current assets/current liabilities, or the 澳洲幸运5官方开奖结果体彩网:quick ratio. A 澳洲幸运5官方开奖结果体彩网:line of credit would be a classic mitigant.

Market Liquidity Risk

Market or asset liquidity risk is asset illiquidity. This is the inability to easily exit a position. You might own 澳洲幸运5官方开奖结果体彩网:real estate but it can only be sold imminently at a fire sale price due to poor market conditions. The asset surely has value bu🐻t the value can't be realized because buyers have temporarily evaporated.

A U.S. 澳洲幸运5官方开奖结果体彩网:Treasury bond would be its virtual opposite. It's considered to be almost risk-free because few imagine the U.S. government will default. This bond also has extremely low liquidity risk. Its owner can easily exit the position at the prevailing market price.

Small positions in S&P 500 stocks are similarly liquid. They can be quickly exited at the market price but positions in many other asset classes, especially in 澳洲幸运5官方开奖结果体彩网:alternative assets, can't be exited with ease.

Market liquidity risk can b🍰e a function of several factors🍬.

• The market microstructure: Exchanges such as commodity futures are typically 澳洲幸运5官方开奖结果体彩网:deep markets but many over-the-counter (OTC) markets are thin.
• Asset type: Simple assets are more liquid than complex assets. CDOs-squared—CDO², 澳洲幸运5官方开奖结果体彩网:structured notes collateralized by CDO tranches, became especially illiquid in the crisis due to their complexity.
• Substitution: The substitution costs are low and the liquidity tends to be higher if a position can be easily replaced with another instrument,
• Time horizon: A seller's urgency tends to exacerbate the liquidity risk. Liquidity risk is less of a threat when a seller is patient.

Note the common feature of both types of liquidity risk. Thꦗey both involve a lack of time. Illiquidity is generally a problem that can be solved with more time.

Measures of Market Liquidity Risk

There are at least three perspectives on market liquidity. The most popular and crudest measure is the 澳洲幸运5官方开奖结果体彩网:bid-ask spread. This is also referred to as width. A low or narrow bid-ask spread is said to be tight and tends to reflect a more 澳洲幸运5官方开奖结果体彩网:liquid market.

Depth refers to the ability of the market to absorb the sale or exit of a position. An individual investor who sells shares of Apple isn't likely to 澳洲幸运5官方开奖结果体彩网:impact the share price but an 澳洲幸运5官方开奖结果体彩网:institutional investor selling a large block of shares in a small 澳洲幸运5官方开奖结果体彩网:capitalization company will probably cause the price to fall.

Resiliency refers to the market's ability to bounce back from temporarily incorrect prices. It measures liquidity in the time dimensions and such models are rare.

The bid-ask spread measures liquidity in the price dimension and is a feature of the market, not the seller or the seller's position. Financial models that incorporate the bid-ask spread adjust for exogenous liquidity and are exogenous liquidity models. High market liquidity would be characterized by the owner of a small position relative to a deep market that exits into a tight bid-ask spread and a highly resilient market.

Position size, relative to the market, is a feature of the seller. Models that use thi🔯s measure liquidity in the quantity dimension and are generally known as﷽ endogenous liquidity models.

What About Volume?

Trading volume is a popular measure of liquidity but it's considered a flawed indicator. High trading volume doesn't necessarily imply high liquidity. The Flash Crash of May 6, 2010 proved this with painful, concrete examples.

Sell 澳洲幸运5官方开奖结果体彩网:algorithms were feeding orders into the system faster than they could be executed, according to the 澳洲幸运5官方开奖结果体彩网:Securities and Exchange Commission (SEC), Volume jumped but many backlog orders weren't filled. "Especially in times of significant volatility, 澳洲幸运5官方开奖结果体彩网:high trading volume is not necessarily a reliable indicator of market liquidity," according to the SEC.

Incorporating Liquidity Risk

One approach in the case of exogenous liquidity risk is to use the bid-ask spread to directly adjust the metric. Risk models are different from 澳洲幸运5官方开奖结果体彩网:valuation models, however, and t🔜his method assumes that there are observable bid/ask prices.

Let's illustrate with 澳洲幸运5官方开奖结果体彩网:value-at-risk (VAR). Assume the daily volatility of a $1,000,000 position is 1.0%. The position has a positive 澳洲幸运5官方开奖结果体彩网:expected return, also referred to as drift, but our horizon is daily so we bring our tiny daily expected ret🍷urn down to zero. This is a common practice.

Let the expected daily return equal zero. The one-tailed deviate at 5.0% is 1.65 if the returns are normally distributed. The 5% left tail of 澳洲幸运5官方开奖结果体彩网:normal distribution is 1.65 澳洲幸运5官方开奖结果体彩网:standard deviations to the𒆙 left of mean. We get this result in Excel with =NORM.S.INV(5%) = -1.645.

The 95% value at risk (VAR) is given by:

$1,000,000 * 1.0% volatility * 1.65 = $16,500

We can say that "only 1/20 days (5% of the time) do we expect the daily loss to exceed $16,500." under these assumptions but this doesn't adjust for liquidity.

Now let's assume that the position is in a single stock where the ask price is $20.40 and the bid price is $19.60 with a midpoint of $20. The spread (%) in percentage terms is:

($20.40 - $19.60) ÷ $20 = 4.0%

The full spread represents the cost of a round trip: buying and selling the stock. We're only interested in the liquidity cost if we have to exit (sell) the position, however, the liquidity adjustment consists of adding one-half (0.5) of the spread. In the case of VaR, we have:

• Liquidity cost (LC) = 0.5 x spread
• Liquidity-adjusted VaR (LVaR) = position ($) * [-drift (%) + volatility *deviate + LC], or
• Liquidity-adjusted VaR (LVaR) = position ($) * [-drift (%) + volatility *deviate + 0.5 * spread].

LVaR = $1,000,000 * [-0% + 1.0% * 1.65 + 0.5 * 4.0%] = $36,500 in our example. The liquidity adjustment increases the VaR by one-half the spread ($1,000,000 * 2% = +$20,000).

The Bottom Line

Liquidity risk can be parsed into funding (cash flow) or market (asset) liquidity risk. Funding liquidity tends to manifest as 澳洲幸运5官方开奖结果体彩网:credit risk or the inability to fund liabilities produces defaults. Market liquidity risk manifests as 澳洲幸运5官方开奖结果体彩网:market risk. The inabilitᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚy to sell an asset drives its market price down or worse renders the market price indecipherable.

Market liquidity risk is a problem created by the interaction of the seller and buyers in the marketplace. It's an endogenous liquidity risk or a feature of the seller if the seller's position is large relative to the market. It's referred to as exogenous liquidity risk if the marketplace has withdrawn buyers, a characteristic of the market that's a collection of buyers. This is a typical indicator that there's an abnormally wide bid-ask spread.

A common way to include market liquidity risk in a 澳洲幸运5官方开奖结果体彩网:financial risk model although not necessarily ☂a valuation model is to adjust or "penalize" the measure by adding/subtracting one-half of the bid-ask spread.