12 terms

Liquidity Risk

Type of Liquidity risk
1. funding liquidity risk: inability to meet the cash flow needs
2. asset liquidity risk: a function of price impact and size of position
Soucre of liquidity risk
1. assets
2. liabilities
3. equity
Liquidity risk starts on the liability side when creditors/investors/ph demand money back --> create asset problem if assets sold at loss
Factors affect asset liquidity risk
1. price impact function
2. size of position
3. prevailing market condition
Assessing asset liquidity risk
1. in absence of anything formal, increase volatility --> increase VaR
2. analyze liquidity costs (eg. bid-ask spread): Liquidity adjustment VaR (fixed/variable spread, LVaR with Execution costs). VaR time horizon should be at least greater than an orderly liquidation period.
3. incorporate liquidity in valuation: a) mark portfolio to bid prices for long position and ask prices for short position. b) treat the additional term as a loss (if the position is to be sold, L1 and L2 represent a certain loss) c) apply reserve: reserve price changes away from the fair value or reserve amount accounting for effects of liquidity risk.
4. effect of price impact: quantity increase -> price decrease.
Drivers of spreads
1. order processing costs: cost of trading. this fixed cost decreases with volume.
2. asymmetric information costs: lack of knowledge will increase spread. market makers can protect themselves by increasing spread.
3. inventory carrying costs: market maker has to hold open positions (cost increases with high volatility, high interest-rates, and lower trading activity/turnover)
Ways to control asset liquidity risk
1. can be controlled through position limit
2. limit the exposure to a single instrument
3. use investment strategy
a) consider the maturity schedule of liabilities when putting together portfolio
b) use swaps to receive fixed in exchange of floating
c) maintain high quality, liquid assets
4. ensure diversification in term and source of funding (equtiy vs. bond or long vs. short term bonds)
Factors affect funding liquidity risk
1. leverage: firms get cash from broker and in return, brokers require posting some collateral (assets). this collateral value is constantly MTM by the broker. if this values falls, the borker will require variataion margin (additional payment) to keep the total amount held above the loan value. if firms do not have enough cash on hand, it will be forced to liquidate some of its other assets.
2. changes in collateral requirements: brokers can increase the haircut when markets are more volatile, creating extra demands on cash
3. mismatches of payment timing: must make payment on hedged postion, but you haven't received offsetting hedge payment yet.
Ways to control funding liquidity risk
1. cash:
2. line of credit: banks allow the clients to borrow up to a prespecified amount.
3. fund raising from other sources: issue debt/equity
4. evaluatoin the likelihood
5. avoid debt covenants or "trigger" options
6. product design: allow for liquidity risk in the product design a) longer lockup period or minimum time for investors to keep thier funds b) a longer redemption notice period for withdrawing funds
7. deposit insurance: commercial banks take short term deposits and lend money in an illiquid mortgage market. deposit inusrance will prevent run-on-banks.
8. allow for transfer of liquidity within and across legal entities.
Assessing funding liquidity risk
1. examine the asset liability structure and potential demands on cash and other sources of liquidity.
2. calculate a funding liquidity ratio = liquid assets (cash) / funding VaR, should consider the time horizon of obligations
3. stress testing
Investment in hedage funds
are illiquid as they often require investors keep their money in the fund for at least one year
The lender's perspective of liquidity risk management
1. don't think that you are protected because your loans were fully collateralized
2. this is due to the situation that when the borrower defaults an the collateral losts value at the same time
3. also this is due to your loans carried no haircuts.
The borrower's perspective of liquidity risk management
1. you have to consider both asset and funding liquidity risks
2. funding liquidity risk can be reduced by
a) a longer lock-up period or minimum time for investors to keep their funds
b) a longer redemption notice period for withdrawing funds
c) but you also need to forsee that you would not be asble to raise new funds as your perforamce dives
3. asset liquidity risk is affected by
a) price-impact function (review the numerical example for price risk): choose a strategy that leads to an optimal tradeoff b/w execution costs and price risk.
b) the size of position: the size of fund can make it difficult to organize an orderly portfolio liquidation
c) prevailing market conditions.