Understanding Liquidity Risk

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Understanding Liquidity Risk

Liquidity risk was not on everyone’s radar prior to the global financial crisis (GFC). Financial models often ignored liquidity risk. However, the GFC inspired a renewed effort to comprehend liquidity risk. One explanation was widespread agreement that the crisis involved a run on the non-depository, shadow banking system, in which suppliers of short-term credit, particularly in the repo market, withdrew liquidity deliberately. They accomplished this inadvertently but indisputably by raising collateral haircuts.

Following the GFC, many major financial institutions and governments are keenly aware of the possibility that liquidity withdrawal may be a nefarious collaborator in spreading shocks across the system—or even aggravating contagion.

Key Takeaways

  • The ease with which an asset or security may be purchased or sold on the market and converted to cash is referred to as liquidity.
  • Liquidity risk is classified into two types: funding liquidity risk and market liquidity risk.
  • A corporate treasurer’s primary worry is funding or cash flow liquidity risk, which examines whether the company can fulfill its obligations.
  • Assetilliquidity, or the inability to readily exit a position, is a market or asset liquidity risk.
  • The bid-ask spread is the most common and simple indicator of liquidity—a low or narrow bid-ask spread is considered to be tight and tends to imply a more liquid market.

What Is Liquidity Risk?

The ease with which an asset or security may be acquired or sold in the market is referred to as liquidity. It essentially indicates the speed with which anything may be transformed to cash. Liquidity risk is classified into two sorts. The first is financing liquidity risk, also known as cash flow risk, and the second is market liquidity risk, also known as asset/product risk.

Funding Liquidity Risk

A corporate treasurer’s primary worry is funding or cash flow liquidity risk, which examines whether the company can fulfill its obligations. The current ratio (current assets/current liabilities) or, for that matter, the quick ratio is a typical measure of financing liquidity risk. A line of credit is a traditional mitigant.

Market Liquidity Risk

Asset illiquidity is a risk associated with market or asset liquidity. The inability to readily depart a position is referred to as this. For example, we may possess real estate, but due to poor market circumstances, we can only sell it now at a fire sale price. The item is undeniably valuable, but since purchasers have temporarily vanished, the value cannot be realized.

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Consider the inverse, a U.S. Treasury bond. True, a US Treasury bond is essentially risk-free since few believe the US government would fail. However, this bond has an exceptionally minimal liquidity risk. Its owner has the ability to simply exit the position at the current market price. Small investments in S&P 500 stocks are also liquid. They may be promptly sold at market value. However, investments in many other asset types, particularly alternative assets, are difficult to sell. In fact, we may classify alternative assets as having a significant liquidity risk.

Understanding Liquidity Risk

Market liquidity risk can be a function of the following:

  • The microstructure of the market. Commodity futures exchanges are normally deep markets, although many over-the-counter (OTC) markets are narrow.
  • Type of asset. Simple assets have a higher liquidity than complicated ones. For example, owing to their complexity, CDOs-squared—structured notes collateralized by CDO tranches—became particularly illiquid during the crisis.
  • Substitution. When a position may be quickly swapped with another instrument, replacement costs are low and liquidity is greater.
  • Horizontal time. If the seller is in a hurry, the liquidity risk is heightened. When a seller is patient, liquidity risk is reduced.

Take note of the following trait shared by both forms of liquidity risk: They both include the reality that there isn’t enough time. In general, illiquidity is an issue that can be remedied with additional time.

Image by Julie Bang © Investopedia2020

Measures of Market Liquidity Risk

According to the following diagram, there are at least three viewpoints on market liquidity. The bid-ask spread is the most often used and rudimentary metric. This is also known as breadth. A tight market has a low or narrow bid-ask spread and tends to represent a more liquid market.

Depth refers to the market’s capacity to absorb the sale or departure of a position. Individual investors selling Apple stock, for example, are unlikely to have an effect on the stock price. An institutional investor, on the other hand, selling a substantial block of shares in a small size business would almost certainly cause the price to decrease. Finally, resilience refers to the market’s capacity to recover from temporary price fluctuations.

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To summarize:

  • The bid-ask spread is a market characteristic that reflects liquidity in the price dimension, not the seller or the seller’s position. Exogenous liquidity models are financial models that use the bid-ask spread to account for exogenous liquidity.
  • The seller’s position size in relation to the market is a distinguishing attribute. Endogenous liquidity models are those that utilize this to quantify liquidity in the quantity dimension.
  • Resiliency evaluates liquidity across time, and such models are presently uncommon.

At one extreme, high market liquidity is defined as the owner of a modest position compared to a deep market that exits into a narrow bid-ask spread and a very resilient market.

A tight market has a low or narrow bid-ask spread and tends to represent a more liquid market.

What About Volume?

Trading volume is a prominent indication of liquidity, although it is currently thought to be inaccurate. A big trade volume does not always suggest a high liquidity. The May 6, 2010 Flash Crash demonstrated this with unpleasant, physical instances.

According to the Securities and Exchange Commission (SEC), in that instance, sell algorithms were putting orders into the system quicker than they could be processed. Although volume increased, many backlog orders were not completed. According to the SEC, “large trading volume is not always a reliable predictor of market liquidity, particularly during periods of severe volatility.”

Incorporating Liquidity Risk

In the event of exogenous liquidity risk, one way is to directly alter the indicator using the bid-ask spread. Please keep in mind that risk models are not the same as valuation models, and this technique implies observable bid/ask prices.

Let’s use value-at-risk as an example (VAR).Assume a $1,000,000 stake has a daily volatility of 1.0%. The position has a positive anticipated return, also known as drift, but since our time horizon is daily, we reduce our little daily expected return to zero. This is a regular occurrence. As a result, set the projected daily return to zero. The one-tailed deviation at 5.0% is 1.65 if the returns are normally distributed. That is, the normal distribution’s 5% left tail is 1.65 standard deviations to the left of the mean. In Excel, we obtain the following result: =NORM.S.INV(5%) = -1.645.

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

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

We may state that “only 1/20 days (5% of the time) do we anticipate the daily loss to surpass $16,500.” However, this does not account for liquidity.

Assume the position is in a single stock with an ask price of $20.40 and a bid price of $19.60, with a $20 midpoint. The spread (%) in percentage terms is:

($20.40 – $19.60) ÷ $20 = 4.0%

The complete spread reflects the cost of buying and selling the stock twice. However, since we are only concerned with the liquidity cost if we need to exit (sell) the position, the liquidity adjustment is equal to one-half (0.5) the spread. When it comes to VaR, we have:

  • The liquidity cost (LC) is equal to 0.5 times the spread.
  • VaR adjusted for liquidity (LVaR) = position ($) * [-drift (%) + volatility *deviate + LC], or
  • Position ($) * [-drift (%) + volatility *deviate + 0.5 * spread] = liquidity-adjusted VaR (LVaR).

In our example,

LVaR = $1,000,000 * [-0% + 1.0% * 1.65 + 0.5 * 4.0%] = $36,500

As a result, the liquidity adjustment raises the VaR by half the spread ($1,000,000 * 2% = +$20,000).

The Bottom Line

Liquidity risk is classified as either financing (cash-flow) or market (asset) liquidity risk. Credit risk, or the inability to finance obligations, tends to emerge as funding liquidity. Market liquidity risk manifests as market risk, or the inability to sell an item, which pulls down its market price or, worse, makes the market price unreadable. Market liquidity risk is a concern caused by the marketplace’s interaction between sellers and buyers. Endogenous liquidity risk exists when the seller’s position is substantial compared to the market (a feature of the seller).If the marketplace has removed buyers, this is known as exogenous liquidity risk—a feature of the market that is a collection of buyers—with an excessively large bid-ask spread being a common sign.

Adjusting or “penalizing” the measure by adding/subtracting one-half of the bid-ask spread is a typical technique to integrate market liquidity risk in a financial risk model (not necessarily a valuation model).

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