Why and how to integrate liquidity risk into a VaR-framework
AbstractWe integrate liquidity risk measured by the weighted spread into a Value-at-Risk (VaR) framework. The weighted spread measure extracts liquidity costs by order size from the limit order book. We show that it is precise from a risk perspective in a wide range of clearly defined situations. Using a unique, representative data set provided by Deutsche Boerse AG, we find liquidity risk to increase traditionally-measured price risk by over 25%, even at standard 10-day horizons and for liquid DAX stocks. We also show that the common approach of simply adding liquidity risk to price risk substantially overestimates total risk because correlation between liquidity and price is neglected. Our results are robust with respect to changes in risk measure, to sample periods and to effects of portfolio diversification. --
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Bibliographic InfoPaper provided by Center for Entrepreneurial and Financial Studies (CEFS), Technische Universität München in its series CEFS Working Paper Series with number 2008-10.
Date of creation: 2008
Date of revision:
asset liquidity; price impact; weighted spread; Xetra Liquidity Measure (XLM); Value-at-Risk; market liquidity risk;
Find related papers by JEL classification:
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
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- Carlo Acerbi & Giacomo Scandolo, 2008. "Liquidity risk theory and coherent measures of risk," Quantitative Finance, Taylor & Francis Journals, vol. 8(7), pages 681-692.
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"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-.
- Anil Bangia & Francis X. Diebold & Til Schuermann & John D. Stroughair, 1998. "Modeling Liquidity Risk, With Implications for Traditional Market Risk Measurement and Management," Center for Financial Institutions Working Papers 99-06, Wharton School Center for Financial Institutions, University of Pennsylvania.
- 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.
- Domowitz, Ian & Hansch, Oliver & Wang, Xiaoxin, 2005. "Liquidity commonality and return co-movement," Journal of Financial Markets, Elsevier, vol. 8(4), pages 351-376, November.
- Damiano Brigo & Mirela Predescu & Agostino Capponi, 2010. "Credit Default Swaps Liquidity modeling: A survey," Papers 1003.0889, arXiv.org, revised Mar 2010.
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