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Liquidity Risk

In: THE ECONOMIC FOUNDATIONS OF RISK MANAGEMENT Theory, Practice, and Applications

Author

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  • Robert Jarrow

Abstract

Liquidity risk occurs when we relax the competitive market assumption and there is a quantity impact on the price from trading an asset, i.e. the more units of an asset one buys, the larger the purchase price per share paid, and the more units of an asset one sells, the smaller the selling price per share received. There are two cases to be studied: a temporary and a permanent quantity impact on the price. A temporary impact on the price occurs when the quantity impact only lasts for an instant, and disappears after the trade is executed. When temporary, the quantity impact on the price is analogous to a transaction cost. As such, the trade has no effect on the future evolution of the asset price process. A permanent impact on the price occurs when the quantity impact lasts for a finite time interval and affects the future evolution of the asset price process. This chapter discusses both of these possibilities.

Suggested Citation

  • Robert Jarrow, 2017. "Liquidity Risk," World Scientific Book Chapters, in: THE ECONOMIC FOUNDATIONS OF RISK MANAGEMENT Theory, Practice, and Applications, chapter 7, pages 59-68, World Scientific Publishing Co. Pte. Ltd..
    • Handle: RePEc:wsi:wschap:9789813147522_0007
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    Citations

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    Cited by:

    1. Gurdip Bakshi & Dilip B. Madan & Frank X. Zhang, 2001. "Understanding the role of recovery in default risk models: empirical comparisons and implied recovery rates," Finance and Economics Discussion Series 2001-37, Board of Governors of the Federal Reserve System (U.S.).
    2. 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.
    3. Damiano Brigo & Mirela Predescu & Agostino Capponi, 2010. "Credit Default Swaps Liquidity modeling: A survey," Papers 1003.0889, arXiv.org, revised Mar 2010.
    4. Luca Erzegovesi, 2002. "VaR and Liquidity Risk.Impact on Market Behaviour and Measurement Issues," Alea Tech Reports 014, Department of Computer and Management Sciences, University of Trento, Italy, revised 14 Jun 2008.
    5. 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.
    6. Alessio Caldarera & Celso Brunetti, 2005. "Asset Prices and Asset Correlations in Illiquid Markets," 2005 Meeting Papers 288, Society for Economic Dynamics.
    7. Ericsson, Jan & Reneby, Joel, 2003. "Valuing Corporate Liabilities," SIFR Research Report Series 15, Institute for Financial Research.
    8. Stuart Turnbull & Jun Yang, 2004. "Modelling the Evolution of Credit Spreads in the United States," Staff Working Papers 04-45, Bank of Canada.
    9. Jun Yang, 2008. "Macroeconomic Determinants of the Term Structure of Corporate Spreads," Staff Working Papers 08-29, Bank of Canada.
    10. Nikolaou, Kleopatra, 2009. "Liquidity (risk) concepts: definitions and interactions," Working Paper Series 1008, European Central Bank.
    11. Hayette Gatfaoui, 2003. "Risque de Défaut et Risque de Liquidité : Une Etude de Deux Composantes du Spread de Crédit," Risk and Insurance 0308005, University Library of Munich, Germany.

    More about this item

    Keywords

    Risk Management; Derivatives; Value-at-Risk; Funding Risk; Financial Engineering;
    All these keywords.

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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