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Why and how to integrate liquidity risk into a VaR-framework

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  • Stange, Sebastian
  • Kaserer, Christoph

Abstract

We 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 Info

Paper provided by Center for Entrepreneurial and Financial Studies (CEFS), Technische Universität München in its series CEFS Working Paper Series with number 2008-10.

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Date of creation: 2008
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Handle: RePEc:zbw:cefswp:200810

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Related research

Keywords: asset liquidity; price impact; weighted spread; Xetra Liquidity Measure (XLM); Value-at-Risk; market liquidity risk;

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References

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  1. Carlo Acerbi & Giacomo Scandolo, 2008. "Liquidity risk theory and coherent measures of risk," Quantitative Finance, Taylor & Francis Journals, Taylor & Francis Journals, vol. 8(7), pages 681-692.
  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, New York University, Leonard N. Stern School of Business- 99-062, New York University, Leonard N. Stern School of Business-.
  3. 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, Institute for Monetary and Economic Studies, Bank of Japan, vol. 18(2), pages 83-127, December.
  4. Domowitz, Ian & Hansch, Oliver & Wang, Xiaoxin, 2005. "Liquidity commonality and return co-movement," Journal of Financial Markets, Elsevier, Elsevier, vol. 8(4), pages 351-376, November.
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Cited by:
  1. 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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