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Liquidity adjusted value-at-risk based on the components of the bid-ask spread

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  • Timotheos Angelidis
  • Alexandros Benos

Abstract

This paper proposes a method of calculating a Liquidity Adjusted Value-at-Risk (L-VaR) measure. Traditional VaR approaches assume perfect markets, where an investor can buy or sell any amount of stock without causing a significant price change. Such a hypothesis is seldom verified in practice, especially in emerging markets, consequently underestimating the VaR risk measure. An attempt is made to remedy this shortcoming by first estimating the bid-ask spread components in order to calculate accurately both the endogeneous and the exogenous liquidity risk. Under this framework, the liquidation price of a position will not be the spread midpoint, but at most the bid price. The Madhavan et al. (1997) model is extended by incorporating the traded volume and find that liquidity risk, for an emerging stock market, displays an inverse U-shape pattern throughout the day. For the high-priced, high-capitalization stocks of the Athens Stock Exchange, it represents 3.40% of total market risk, while for the low capitalization ones, it is even higher at 11%. VaR measures are then adjusted for such spread variation since, neglecting such effect, leads so serious failure of VaR backtesting.

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File URL: http://www.tandfonline.com/doi/abs/10.1080/09603100500426440
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Bibliographic Info

Article provided by Taylor & Francis Journals in its journal Applied Financial Economics.

Volume (Year): 16 (2006)
Issue (Month): 11 ()
Pages: 835-851

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Handle: RePEc:taf:apfiec:v:16:y:2006:i:11:p:835-851

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References

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Citations

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Cited by:
  1. Timotheos Angelidis & Alexandros Benos, . "The Components of the Bid-Ask Spread: The case of the Athens Stock Exchange," Working Papers 0615, University of Crete, Department of Economics.
  2. Al Janabi, Mazin A.M., 2012. "Optimal commodity asset allocation with a coherent market risk modeling," Review of Financial Economics, Elsevier, vol. 21(3), pages 131-140.
  3. Damiano Brigo & Mirela Predescu & Agostino Capponi, 2010. "Credit Default Swaps Liquidity modeling: A survey," Papers 1003.0889, arXiv.org, revised Mar 2010.
  4. Al Janabi, Mazin A. M., 2009. "Asset Market Liquidity Risk Management: A Generalized Theoretical Modeling Approach for Trading and Fund Management Portfolios," MPRA Paper 19498, University Library of Munich, Germany.
  5. Petr Strnad, 2009. "Market liquidity risk and its incorporation into value at risk," Acta Oeconomica Pragensia, University of Economics, Prague, vol. 2009(2), pages 21-37.
  6. Rouetbi Emnal & Mamoghli Chokri, 2014. "Measuring Liquidity Risk in an Emerging Market: Liquidity Adjusted Value at Risk Approach for High Frequency Data," International Journal of Economics and Financial Issues, Econjournals, vol. 4(1), pages 40-53.

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