Market liquidity and its incorporation into risk management
The excessively optimistic assessment of market liquidity, i.e. the belief that transactions can be settled at current prices without any notable delays or transaction costs, may be a serious threat to financial stability–the near failure of the LTCM hedge fund in 1998 was a case in point. Admittedly, the financial community today appears to have a better grasp of the risks arising from liquidity illusion. The fact nonetheless remains that current risk management tools, particularly the most common Value at Risk (VaR) measures, do not capture this complex component of market risk satisfactorily. In fact, standard VaR calculations do not take specific account of the risk to which a portfolio is exposed at the time it is liquidated. This article aims to explore the different aspects of liquidity risk and provide signposts to methods for incorporating this risk into existing risk control tools. We fi rst examine “normal” or average liquidity risk, which corresponds to the costs of liquidating or hedging a position in tranquil periods, then illiquidity risk that arises in crisis periods and results in the market’s inability to absorb order flows without violent price adjustments. Two separate methodologies, which must nonetheless be combined in a comprehensive approach, are required to analyse these two situations. In the first case we seek to assess the frictions that emerge in imperfect markets by using bid-ask spread measures and by analysing the negative impact on prices resulting from the liquidation of a sizeable portfolio. In the case of extreme risk, we assess the potential consequences of occurrences that are rare, fundamentally uncertain and systemically important. In each case, we suggest and describe a number of techniques that aim to incorporate these elements into the risk measurement and management systems used by private market participants, while underscoring the obstacles to application given the frequent unavailability of the data required. We show that these techniques are relevant because they provide a more cautious and more realistic assessment of financial institutions’ exposure to risk. Lastly, it is in market participants’ own interest for central banks and supervisory bodies to have at their disposal the information required to construct indicators for monitoring market liquidity or conducting suffi ciently comprehensive stress tests in order to assess the fi nancial system’s resilience to liquidity shocks, while taking into account all the externalities that market participants do not individually consider.
Volume (Year): (2006)
Issue (Month): 8 (May)
|Contact details of provider:|| Postal: Banque de France 31 Rue Croix des Petits Champs LABOLOG - 49-1404 75049 PARIS|
Web page: http://www.banque-france.fr/
More information through EDIRC
When requesting a correction, please mention this item's handle: RePEc:bfr:fisrev:2006:8:2. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Michael brassart)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.