Chapter 24
Liquidity Risk
©2015 by Scott Warlow 1
Types of Liquidity Risk
• Liquidity trading risk
• Liquidity funding risk
©2015 by Scott Warlow 2
Liquidity Trading Risk
• Price received for an asset depends on
– The mid market price
– How much is to be sold
– How quickly it is to be sold
– The economic environment
• As we found in August 2007 transparency
is a factor that affects liquidity
©2015 by Scott Warlow 3
Bid-Offer Spread As a Function
of Quantity (Figure 24.1, page 500)
Offer Price
Bid Price
Quantity
©2015 by Scott Warlow 4
Bid-Offer Spread (page 502)
Offer price Bid price
Proportional Bid-offer spread
Mid-market price
Cost of liquidation in normal markets is
n
1
i 1 2
si αi
where n is the number of positions, i is the position
in the ith instrument, and si is the proportional
bid-offer spread for the ith instrument.
©2015 by Scott Warlow 5
Cost of Liquidation in Stressed
Markets
This is
n
1
i 1 2
( i i ) i
where i and i are the mean and standard
deviation of the spread and gives the required
confidence level
©2015 by Scott Warlow 6
Liquidity-Adjusted VaR (page 504)
n
1
Liquidity-adjusted VaR VaR si i
i 1 2
n
1
Liquidity-adjusted stressed VaR VaR ( i i ) i
i 1 2
©2015 by Scott Warlow 7
Unwinding a Position Optimally
(pages 505-506)
• Suppose dollar bid-offer spread as a function of units
traded is p(q)
• Suppose standard deviation of mid-market price
changes per day is
• Suppose that qi is amount traded on day i and xi is
amount held at end of day i (xi = xi-1−qi)
• Trader’s objective might be to choose the qi to
minimize n
1
n 2 2
i 1
xi qi p(qi )
i 1 2
©2015 by Scott Warlow 8
Example 24.3 (page 506)
• A trader wishes to unwind a position in 100
million units over 5 days
• p(q) = a + becq with a = 0.1, b = 0.05, and
c = 0.03
• = 0.1
• With 95% confidence level the amounts
that should be traded on successive days is
48.9, 30.0, 14.1, 5.1, and 1.9
©2015 by Scott Warlow 9
Other Measures of Trading
Liquidity
• Volume of trading per day
• Price impact of a trade
• Absolute value of daily return divided by
daily dollar volume (suggested by Amihud
in 2002)
Research shows that an asset’s expected
return increases as its liquidity decreases
©2015 by Scott Warlow 10
Liquidity Funding Risk
• Sources of liquidity
– Liquid assets
– Ability to liquidate trading positions
– Wholesale and retail deposits
– Lines of credit and the ability to borrow at short
notice
– Securitization
– Central bank borrowing
©2015 by Scott Warlow 11
Basel III Regulation
• Liquidity coverage ratio: designed to make
sure that the bank can survive a 30-day
period of acute stress
• Net stable funding ratio: a longer term
measure designed to ensure that stability of
funding sources is consistent with the
permanence of the assets that have to be
funded
©2015 by Scott Warlow 12
Examples of Liquidity Funding
Problems
• Northern Rock (Business Snapshot 24.1, pages 508-
509)
• Ashanti Goldfields (Business Snapshot 24.2, page
511)
• Metallgesellschaft (Business Snapshot 24.3, page
512)
©2015 by Scott Warlow 13
Liquidity Black Holes
• A liquidity black hole occurs when most
market participants want to take one side of
the market and liquidity dries up
• Examples:
– Crash of 1987 (Business Snapshot 24.4, page 518)
– British Insurance Companies (Business Snapshot 3.1,
page 52)
– LTCM (Business Snapshot 22.1, page 467)
©2015 by Scott Warlow 14
Positive and Negative Feedback
Trading
• A positive feedback trader buys after a price
increase and sells after a price decrease
• A negative feedback trader buys after a
price decrease and sells after a price
increase
• Positive feedback trading can create or
accentuate a black hole
©2015 by Scott Warlow 15
Reasons for Positive Feedback
Trading
• Computer models incorporating stop-loss
trading
• Dynamic hedging a short option position
• Creating a long option position
synthetically
• Margin calls
©2015 by Scott Warlow 16
The Impact of Regulation
• If all financial institutions were regulated in
the same way, they would tend to react in
the same way to market movements
• This has the potential to create a liquidity
black hole
©2015 by Scott Warlow 17
The Leveraging Cycle (Figure 24.2)
©2015 by Scott Warlow 18
The Deleveraging Cycle (Figure 24.3)
©2015 by Scott Warlow 19
Is Liquidity Improving?
• Spreads are narrowing
• Arguably the risks of liquidity black holes
are now greater than they used to be
• It is important to have diversity in financial
markets, where different groups of investors
are acting independently of each other
©2015 by Scott Warlow 20
