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Modeling Liquidity Risk With Implications for Traditional Market Risk Measurement and Management

  • Anil Bangia
  • Francis X. Diebold
  • Til Schuermann
  • John D. Stroughair

Market risk management traditionally has focussed on the distribution of portfolio value changes resulting from moves in the midpoint of bid and ask prices. Hence the market risk is really in a “pure” form: risk in an idealized market with no “friction” in obtaining the fair price. However, many markets possess an additional liquidity component that arises from a trader not realizing the mid-price when liquidating her position, but rather the mid-price minus the bid-ask spread. We argue that liquidity risk associated with the uncertainty of the spread, particularly for thinly traded or emerging market securities under adverse market conditions, is an important part of overall risk and is therefore an important component to model.

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Paper provided by New York University, Leonard N. Stern School of Business- in its series New York University, Leonard N. Stern School Finance Department Working Paper Seires with number 99-062.

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Date of creation: 21 Dec 1998
Date of revision:
Handle: RePEc:fth:nystfi:99-062
Contact details of provider: Postal: U.S.A.; New York University, Leonard N. Stern School of Business, Department of Economics . 44 West 4th Street. New York, New York 10012-1126
Phone: (212) 998-0100
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  1. Darryll Hendricks, 1996. "Evaluation of value-at-risk models using historical data," Economic Policy Review, Federal Reserve Bank of New York, issue Apr, pages 39-69.
  2. Bertsimas, Dimitris & Lo, Andrew W., 1998. "Optimal control of execution costs," Journal of Financial Markets, Elsevier, vol. 1(1), pages 1-50, April.
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