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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 under normal conditions traditionally has focussed on the distribution of portfolio value changes resulting from moves in the mid-price. 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. We develop a simple liquidity risk methodology that can be easily and seamlessly integrated into standard value-at-risk models, and we show that ignoring the liquidity effect can produce underestimates of market risk in emerging markets by as much as 25-30%. Furthermore, we show that the BIS inadvertently is already monitoring liquidity risk, and that by not modeling it explicitly and therefore capitalizing against it, banks will be experiencing surprisingly many violations of capital requirements, particularly if their portfolios are concentrated in emerging markets.

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File URL: http://fic.wharton.upenn.edu/fic/papers/99/9906.pdf
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Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 99-06.

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Date of creation: Dec 1998
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Handle: RePEc:wop:pennin:99-06
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  1. Bertsimas, Dimitris & Lo, Andrew W., 1998. "Optimal control of execution costs," Journal of Financial Markets, Elsevier, vol. 1(1), pages 1-50, April.
  2. 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.
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