Modeling Liquidity Risk
With Implications for Traditional Market Risk Measurement and Management
December 21, 1998
Anil Bangia, Francis X. Diebold, Til Schuermann and John D. Stroughair
ABSTRACT
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.
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.
Subject: Investments/Volatility of Asset Prices; Investments/Econometrics; Financial Risk Management
Classification: Empirical/Theoretical
Diebold: (610)585-4057 fdiebold@stern.nyu.edu
All other authors contact info: Oliver, Wyman and Company
666 Fifth Avenue, 16th floor New York, NY 10103 (212) 541-8100
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