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Research toward the Practical Application of Liquidity Risk Evaluation Methods

Author

Listed:
  • Hisata, Yoshifumi

    (Institute for Monetary & Econ Studies, Bank of Japan)

  • Yamai, Yasuhiro

    (Institute for Monetary & Econ Studies, Bank of Japan)

Abstract

This paper proposes a practical framework for the quantification of Liquidity-adjusted Value at Risk ("L-VaR") incorporating the market liquidity of financial products. This framework incorporates the mechanism of the market impact caused by the investor's own dealings through adjusting Value-at-Risk according to the level of market liquidity and the scale of the investor's position. Specifically, the optimal execution strategy for liquidating the investor's entire position is first calculated taking the market impact into account. Then the maximum loss that may be incurred by price fluctuations under optimal execution strategy is calculated as L-VaR. This paper presents a specific model providing a closed-form solution for calculating L-VaR, and examines whether this framework can be applied to the practices of financial risk management by calculating numerical examples. It also demonstrates that this L-VaR calculation framework may be applied under more general conditions, such as (1) when the market impact is uncertain, (2) when the investor's portfolio consists of multiple financial assets, and (3) when there is a non-linear relationship between the market impact and the trading volume.

Suggested Citation

  • Hisata, Yoshifumi & Yamai, Yasuhiro, 2000. "Research toward the Practical Application of Liquidity Risk Evaluation Methods," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 18(2), pages 83-127, December.
    • Handle: RePEc:ime:imemes:v:18:y:2000:i:2:p:83-127
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    References listed on IDEAS

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    1. Holthausen, Robert W. & Leftwich, Richard W. & Mayers, David, 1987. "The effect of large block transactions on security prices: A cross-sectional analysis," Journal of Financial Economics, Elsevier, vol. 19(2), pages 237-267, December.
    2. Anil Bangia & Francis X. Diebold & Til Schuermann & John D. Stroughair, 1998. "Modeling Liquidity Risk With Implications for Traditional Market Risk Measurement and Management," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-062, New York University, Leonard N. Stern School of Business-.
    3. Bertsimas, Dimitris & Lo, Andrew W., 1998. "Optimal control of execution costs," Journal of Financial Markets, Elsevier, vol. 1(1), pages 1-50, April.
    4. Robert Jarrow, 2017. "Liquidity Risk," World Scientific Book Chapters, in: THE ECONOMIC FOUNDATIONS OF RISK MANAGEMENT Theory, Practice, and Applications, chapter 7, pages 59-68, World Scientific Publishing Co. Pte. Ltd..
    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. Timotheos Angelidis & Alexandros Benos, 2009. "The Components of the Bid‐Ask Spread: the Case of the Athens Stock Exchange," European Financial Management, European Financial Management Association, vol. 15(1), pages 112-144, January.
    2. Mazin A.M. Al Janabi, 2010. "A generalized theoretical modelling approach for the assessment of economic-capital under asset market liquidity risk constraints," The Service Industries Journal, Taylor & Francis Journals, vol. 31(13), pages 2193-2221, April.
    3. Mazin A.M. Al Janabi, 2021. "Is optimum always optimal? A revisit of the mean‐variance method under nonlinear measures of dependence and non‐normal liquidity constraints," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 40(3), pages 387-415, April.
    4. Timotheos Angelidis & Alexandros Benos, 2006. "Liquidity adjusted value-at-risk based on the components of the bid-ask spread," Applied Financial Economics, Taylor & Francis Journals, vol. 16(11), pages 835-851.
    5. Luca Erzegovesi, 2002. "VaR and Liquidity Risk.Impact on Market Behaviour and Measurement Issues," Alea Tech Reports 014, Department of Computer and Management Sciences, University of Trento, Italy, revised 14 Jun 2008.
    6. Mazin A. M. Al Janabi, 2009. "Market Liquidity And Strategic Asset Allocation: Applications To Gcc Stock Exchanges," Middle East Development Journal (MEDJ), World Scientific Publishing Co. Pte. Ltd., vol. 1(02), pages 227-254.
    7. Al Janabi Mazin A. M., 2010. "Incorporating Asset Liquidity Effects in Risk-Capital Modeling," Review of Middle East Economics and Finance, De Gruyter, vol. 6(1), pages 60-89, July.
    8. Qixuan Luo & Yu Shi & Xuan Zhou & Handong Li, 2021. "Research on the Effects of Institutional Liquidation Strategies on the Market Based on Multi-agent Model," Computational Economics, Springer;Society for Computational Economics, vol. 58(4), pages 1025-1049, December.
    9. Michael Ha & Lihui Zheng & Danny Lo & Alexis Suen, 2016. "Investment Portfolio Liquidity Risk Management," International Journal of Financial Markets, Research Academy of Social Sciences, vol. 2(1), pages 1-5.
    10. Ourir, Awatef & Snoussi, Wafa, 2012. "Markets liquidity risk under extremal dependence: Analysis with VaRs methods," Economic Modelling, Elsevier, vol. 29(5), pages 1830-1836.
    11. Stange, Sebastian & Kaserer, Christoph, 2008. "Why and how to integrate liquidity risk into a VaR-framework," CEFS Working Paper Series 2008-10, Technische Universität München (TUM), Center for Entrepreneurial and Financial Studies (CEFS).
    12. Petr Strnad, 2009. "Market liquidity risk and its incorporation into value at risk [Riziko tržní likvidity a jeho zohlednění v ukazateli value at risk]," Acta Oeconomica Pragensia, Prague University of Economics and Business, vol. 2009(2), pages 21-37.
    13. Mazin A.M. Al Janabi, 2011. "Modeling coherent trading risk parameters under illiquid market perspective," Studies in Economics and Finance, Emerald Group Publishing Limited, vol. 28(4), pages 301-320, October.

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    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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