Dowd, Measuring Market Risk, 2nd Edition
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1 P2.T7. Operational & Integrated Risk Management Dowd, Measuring Market Risk, 2nd Edition Bionic Turtle FRM Study Notes Reading 53 By David Harper, CFA FRM CIPM
2 DOWD CHAPTER 14: ESTIMATING LIQUIDITY RISKS... 3 DEFINE LIQUIDITY RISK AND DESCRIBE FACTORS THAT INFLUENCE LIQUIDITY EXPLAIN THE BID-ASK SPREAD AS A MEASURE OF LIQUIDITY DEFINE EXOGENOUS AND ENDOGENOUS LIQUIDITY
3 Dowd Chapter 14: Estimating Liquidity Risks Define liquidity risk and describe factors that influence liquidity. Explain the bid-ask spread as a measure of liquidity. Define exogenous and endogenous liquidity. Describe the challenges of estimating liquidity-adjusted VaR (LVaR) Describe and calculate LVaR using the Constant Spread approach and the Exogenous Spread approach. Discuss Endogenous Price approaches to LVaR, their motivation and limitations. Describe liquidity at risk (LaR) and discuss the factors that affect future cash flows. Explain the role of liquidity in crisis situations and describe approaches to estimating crisis liquidity risk. Define liquidity risk and describe factors that influence liquidity. Liquidity is the ability of a trader to execute a trade or liquidate a position with little or no cost, risk or inconvenience. Liquidity is function of the market: Number of traders in the market, Frequency and size of trades, Time it takes to carry out a trade, and Cost (and sometimes risk) of transacting. Liquidity is also a function of the position (e.g., commodity?) or instrument traded: Exchange-traded positions have more liquid markets than OTC Width (bid-ask): exogenous Depth (quantity): endogenous The notion of liquidity refers to the ability of a trader to execute a trade or liquidate a position with little or no cost, risk or inconvenience. Liquidity is a function of the market, and depends on such factors as the number of traders in the market, the frequency and size of trades, the time it takes to carry out a trade, and the cost (and sometimes risk) of transacting. It also depends on the commodity or instrument traded, and more standardized instruments (e.g., FX or equities) tend to have more liquid markets than non-standardized or tailor-made instruments (e.g., such as over-the-counter (OTC) derivatives). Dowd 3
4 Explain the bid-ask spread as a measure of liquidity. The bid-ask spread is a classic measure of exogenous liquidity risk; i.e., the bid-ask spread is viewed as an exogenous factor. Imperfect liquidity implies that there is no such thing as the going market price. Instead, there are two going market prices Higher ASK price: price at which a trader sells, and Lower BID price: price at which trader buys The market price is (often) quoted as an average of the bid and ask prices The difference between the bid and ask prices is a cost of liquidity. We should allow for this cost in estimating market risk measures. The bid ask spread also has an associated risk, because the spread itself is a random variable. This means there is some risk associated with the price we can obtain, even if the fictional mid-spread price is given. Other things being equal, if the spread rises, the costs of closing out our position will rise, so the risk that the spread will rise should be factored into our risk measures along with the usual market price risk. Imperfect liquidity also implies that there is no such thing as the going market price. Instead, there are two going market prices an ask price, which is the price at which a trader sells, and a (lower) bid price, which is the price at which a trader buys. The market price is often quoted is just an average of the bid and ask prices, and this price is fictional because no one actually trades at this price. The difference between the bid and ask prices is a cost of liquidity, and in principle we should allow for this cost in estimating market risk measures. The bid ask spread also has an associated risk, because the spread itself is a random variable. This means there is some risk associated with the price we can obtain, even if the fictional mid-spread price is given. Other things being equal, if the spread rises, the costs of closing out our position will rise, so the risk that the spread will rise should be factored into our risk measures along with the usual market price risk. Dowd Define exogenous and endogenous liquidity. Exogenous: If our position is sufficiently small relative to the market, we can regard our spread risk as exogenous to us (i.e., independent of our own trading), for any given holding period. Endogenous: If we sell, and the act of selling reduces the price, then this marketprice response creates an additional loss relative to the case where the market price is exogenous, and we need to add this extra loss to our VaR. The liquidity adjustment will also depend on the responsiveness of market prices to our trade: the more responsive the market price, the bigger the loss. 4
5 Endogenous versus exogenous variables: analogy between liquidity and Merton We should also take account of a further distinction. If our position is small relative to the size of the market (e.g., because we are a very small player in a very large market), then our trading should have a negligible impact on the market price. In such circumstances we can regard the bid ask spread as exogenous to us, and we can assume that the spread is determined by the market beyond our control. However, if our position is large relative to the market, our activities will have a noticeable effect on the market itself, and can affect both the market price and the bid ask spread. For example, if we suddenly unload a large position, we should expect the market price to fall and the bid ask spread to widen. Dowd In the quotation below, Carol Alexander distinguishes between market liquidity risk and funding liquidity risk. Further, within market liquidity risk, she distinguishes between exogenous and endogenous factors. There are two types of liquidity risk: Market liquidity risk is the risk associated with an inability to perform market transactions at the current mark-to-market value. Market liquidity is commonly measured by an exogenous factor, i.e. the relative size of the bid ask spread, and by and endogenous factor, i.e. market impact. Market impact relates to market depth, i.e. the ability to trade a substantial amount without seriously impacting the mid price. Funding liquidity risk refers to the inability to raise funds or collateral to meet obligations. Funding illiquidity is a prime risk driver of default risk, but not of market risk. Carol Alexander, Market Risk Analysis, Volume 4, page 392 5
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