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

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Author Info
Timotheos Angelidis
Alexandros Benos

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

Volume (Year): 16 (2006)
Issue (Month): 11 (July)
Pages: 835-851
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Handle: RePEc:taf:apfiec:v:16:y:2006:i:11:p:835-851

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  8. Huang, Roger D & Stoll, Hans R, 1997. "The Components of the Bid-Ask Spread: A General Approach," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 10(4), pages 995-1034.
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  14. de Jong, Frank & Nijman, Theo & Roell, Ailsa, 1996. "Price effects of trading and components of the bid-ask spread on the Paris Bourse," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 193-213, June. [Downloadable!] (restricted)
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  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. [Downloadable!]
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