Liquidity risk
Encyclopedia
In finance
, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).
Funding liquidity - Risk that liabilities:
cannot do it because nobody in the market
wants to trade that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade.
Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if one party
cannot find another party
interested in trading the asset, this can potentially be only a problem of the market
participants with finding each other. This is why liquidity risk is usually found to be higher in emerging markets or low-volume markets.
Liquidity risk is financial risk
due to uncertain liquidity. An institution might lose liquidity if its credit rating
falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity.
Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty
that owes it a payment
defaults, the firm will have to raise cash from other sources to make its payment
. Should it be unable to do so, it too will default. Here, liquidity risk
is compounding credit risk
.
A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk example—the two payments are offsetting, so they entail credit risk but not market risk. Another example is the 1993 Metallgesellschaft debacle. Futures contracts were used to hedge an Over-the-counter finance OTC obligation. It is debatable whether the hedge was effective from a market risk standpoint, but it was the liquidity crisis
caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions.
Accordingly, liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset-liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults.
Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organization's cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general approach using scenario analysis might entail the following high-level steps:
Because balance sheet
s differ so significantly from one organization to the next, there is little standardization in how such analyses are implemented.
Regulators are primarily concerned about systemic and implications of liquidity risk.
As a static measure of liquidity risk it gives no indication of how the gap would change with an increase in the firm's marginal funding cost.
on the bank's marginal funding cost rises by a small amount as the liquidity risk elasticity. For banks this would be measured as a spread over libor, for nonfinancials the LRE would be measured as a spread over commercial paper rates.
Problems with the use of liquidity risk elasticity are that it assumes parallel changes in funding spread across all maturities and that it is only accurate for small changes in funding spreads.
is used by market participants as an asset liquidity measure. To compare different products the ratio of the spread to the product's mid price can be used. The smaller the ratio the more liquid the asset is.
This spread is composed of operational, administrative, and processing costs as well as the compensation required for the possibility of trading with a more informed trader.
as the amount of an asset that can be bought and sold at various bid-ask spreads. Slippage is related to the concept of market depth. Knight and Satchell mention a flow trader needs to consider the effect of executing a large order on the market and to adjust the bid-ask spread accordingly. They calculate the liquidity cost as the difference of the execution price and the initial execution price.
. It can be defined at VAR + ELC (Exogenous Liquidity Cost). The ELC is the worst expected half-spread at a particular confidence level.
Another adjustment is to consider VAR over the period of time needed to liquidate the portfolio. VAR can be calculated over this time period. The BIS
mentions "... a number of institutions are exploring the use of liquidity adjusted-VAR, in which the holding periods in the risk assessment are adjusted by the length of time required to unwind positions."
. The Liquidity at risk measure is suggested. A country's liquidity position under a range of possible outcomes for relevant financial variables (exchange rates, commodity prices, credit spreads, etc.) is considered. It might be possible to express a standard in terms of the probabilities of different outcomes. For example, an acceptable debt structure could have an average maturity—averaged over estimated distributions for relevant financial variables—in excess of a certain limit. In addition, countries could
be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowing for one year with a certain ex ante probability, such as 95 percent of the time.
will be there when needed."
lost roughly $6bn in the natural gas
futures market back in September 2006. Amaranth had a concentrated, undiversified position in its natural gas strategy. The trader had used leverage to build a very large position. Amaranth’s positions were staggeringly large, representing around 10% of the global market in natural gas futures. Chincarini notes that firms need to manage liquidity risk explicitly. The inability to sell a futures contract at or near the latest quoted price is related to one’s concentration in the security. In Amaranth’s case, the concentration was far too high and there were no natural
counterparties when they needed to unwind the positions. Chincarini (2006) argues that part of the loss Amaranth incurred was due to asset illiquidity. Regression analysis on the 3 week return on natural gas future contracts from August 31, 2006 to September 21, 2006 against the excess open interest suggested that contracts whose open interest was much higher on August 31, 2006 than the historical normalized value, experienced larger negative returns.
suffered from funding liquidity risk in September 2007 following the subprime crisis. The firm suffered from liquidity issues despite being solvent at the time, because maturing loans and deposits could not be renewed in the short-term money markets . In response, the FSA
now places greater supervisory focus on liquidity risk especially with regard to "high-impact retail firms".
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).
Types of Liquidity Risk
Market liquidity - An asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of market risk. This can be accounted for by:- Widening bid/offer spread
- Making explicit liquidity reserves
- Lengthening holding period for VaR calculations
Funding liquidity - Risk that liabilities:
- Cannot be met when they fall due
- Can only be met at an uneconomic price
- Can be name-specific or systemic
Causes of liquidity risk
Liquidity risk arises from situations in which a party interested in trading an assetAsset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
cannot do it because nobody in the market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
wants to trade that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade.
Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if one party
Party
A party is a gathering of people who have been invited by a host for the purposes of socializing, conversation, or recreation. A party will typically feature food and beverages, and often music and dancing as well....
cannot find another party
Party
A party is a gathering of people who have been invited by a host for the purposes of socializing, conversation, or recreation. A party will typically feature food and beverages, and often music and dancing as well....
interested in trading the asset, this can potentially be only a problem of the market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
participants with finding each other. This is why liquidity risk is usually found to be higher in emerging markets or low-volume markets.
Liquidity risk is financial risk
Financial risk
Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss...
due to uncertain liquidity. An institution might lose liquidity if its credit rating
Credit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...
falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity.
Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty
Counterparty
A counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
that owes it a payment
Payment
A payment is the transfer of wealth from one party to another. A payment is usually made in exchange for the provision of goods, services or both, or to fulfill a legal obligation....
defaults, the firm will have to raise cash from other sources to make its payment
Payment
A payment is the transfer of wealth from one party to another. A payment is usually made in exchange for the provision of goods, services or both, or to fulfill a legal obligation....
. Should it be unable to do so, it too will default. Here, liquidity risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
is compounding credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
.
A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk example—the two payments are offsetting, so they entail credit risk but not market risk. Another example is the 1993 Metallgesellschaft debacle. Futures contracts were used to hedge an Over-the-counter finance OTC obligation. It is debatable whether the hedge was effective from a market risk standpoint, but it was the liquidity crisis
Liquidity crisis
In financial economics, liquidity is a catch-all term that may refer to several different yet closely related concepts. Among other things, it may refer to Asset Market liquidity In financial economics, liquidity is a catch-all term that may refer to several different yet closely related...
caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions.
Accordingly, liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset-liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults.
Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organization's cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general approach using scenario analysis might entail the following high-level steps:
- Construct multiple scenarios for market movements and defaults over a given period of time
- Assess day-to-day cash flows under each scenario.
Because balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
s differ so significantly from one organization to the next, there is little standardization in how such analyses are implemented.
Regulators are primarily concerned about systemic and implications of liquidity risk.
Liquidity gap
Culp defines the liquidity gap as the net liquid assets of a firm. The excess value of the firm's liquid assets over its volatile liabilities. A company with a negative liquidity gap should focus on their cash balances and possible unexpected changes in their values.As a static measure of liquidity risk it gives no indication of how the gap would change with an increase in the firm's marginal funding cost.
Liquidity risk elasticity
Culp denotes the change of net of assets over funded liabilities that occurs when the liquidity premiumLiquidity premium
Liquidity premium is a term used to explain a difference between two types of financial securities , that have all the same qualities except liquidity. For example:...
on the bank's marginal funding cost rises by a small amount as the liquidity risk elasticity. For banks this would be measured as a spread over libor, for nonfinancials the LRE would be measured as a spread over commercial paper rates.
Problems with the use of liquidity risk elasticity are that it assumes parallel changes in funding spread across all maturities and that it is only accurate for small changes in funding spreads.
Bid-offer spread
The bid-offer spreadBid-offer spread
The bid–offer spread for securities is the difference between the prices quoted for an immediate sale and an immediate purchase...
is used by market participants as an asset liquidity measure. To compare different products the ratio of the spread to the product's mid price can be used. The smaller the ratio the more liquid the asset is.
This spread is composed of operational, administrative, and processing costs as well as the compensation required for the possibility of trading with a more informed trader.
Market depth
Hachmeister refers to market depthMarket depth
In finance, market depth is the size of an order needed to move the market a given amount. If the market is deep, a large order is needed to change the price. Market depth closely relates to the notion of liquidity, the ease to find a trading partner for a given order: a deep market is also a...
as the amount of an asset that can be bought and sold at various bid-ask spreads. Slippage is related to the concept of market depth. Knight and Satchell mention a flow trader needs to consider the effect of executing a large order on the market and to adjust the bid-ask spread accordingly. They calculate the liquidity cost as the difference of the execution price and the initial execution price.
Immediacy
Immediacy refers to the time needed to successfully trade a certain amount of an asset at a prescribed cost.Resilience
Hachmeister identifies the fourth dimension of liquidity as the speed with which prices return to former levels after a large transaction. Unlike the other measures resilience can only be determined over a period of time.Liquidity-adjusted value at risk
Liquidity-adjusted VAR incorporates exogenous liquidity risk into Value at RiskValue at risk
In financial mathematics and financial risk management, Value at Risk is a widely used risk measure of the risk of loss on a specific portfolio of financial assets...
. It can be defined at VAR + ELC (Exogenous Liquidity Cost). The ELC is the worst expected half-spread at a particular confidence level.
Another adjustment is to consider VAR over the period of time needed to liquidate the portfolio. VAR can be calculated over this time period. The BIS
Bank for International Settlements
The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...
mentions "... a number of institutions are exploring the use of liquidity adjusted-VAR, in which the holding periods in the risk assessment are adjusted by the length of time required to unwind positions."
Liquidity at risk
Greenspan (1999) discusses management of foreign exchange reservesForeign exchange reserves
Foreign-exchange reserves in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, Special Drawing Rights and International Monetary Fund reserve positions...
. The Liquidity at risk measure is suggested. A country's liquidity position under a range of possible outcomes for relevant financial variables (exchange rates, commodity prices, credit spreads, etc.) is considered. It might be possible to express a standard in terms of the probabilities of different outcomes. For example, an acceptable debt structure could have an average maturity—averaged over estimated distributions for relevant financial variables—in excess of a certain limit. In addition, countries could
be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowing for one year with a certain ex ante probability, such as 95 percent of the time.
Scenario analysis-based contingency plans
The FDIC discuss liquidity risk management and write "Contingency funding plans should incorporate events that could rapidly affect an institution’s liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty.". Greenspan's liquidity at risk concept is an example of scenario based liquidity risk management.Diversification of liquidity providers
If several liquidity providers are on call then if any of those providers increases its costs of supplying liquidity, the impact of this is reduced. The American Academy of Actuaries wrote "While a company is in good financial shape, it may wish to establish durable, ever-green (i.e., always available) liquidity lines of credit. The credit issuer should have an appropriately high credit rating to increase the chances that the resourceswill be there when needed."
Derivatives
Bhaduri, Meissner and Youn discuss five derivatives created specifically for hedging liquidity risk.:- Withdrawal option: A put of the illiquid underlying at the market price.
- Bermudan-style return put option: Right to put the option at a specified strike.
- Return swap: Swap the underlying's return for LIBOR paid periodicially.
- Return swaption: Option to enter into the return swap.
- Liquidity option: "Knock-in" barrier optionBarrier optionIn finance, a barrier option is a financial derivative which either springs into existence upon the occurrence of the event of the price of the underlying asset breaching a barrier or whose existence is extinguished upon the occurrence of the event of the price of the underlying asset breaching a...
, where the barrier is a liquidity metric.
Amaranth Advisors LLC - 2006
Amaranth AdvisorsAmaranth Advisors
Amaranth Advisors LLC was an American investment adviser managing multi-strategy hedge fund founded by Nicholas Maounis and headquartered in Greenwich, Connecticut. The firm had up to $9 billion in assets under management and collapsed in September 2006 after losing in excess of $5 billion on...
lost roughly $6bn in the natural gas
Natural gas
Natural gas is a naturally occurring gas mixture consisting primarily of methane, typically with 0–20% higher hydrocarbons . It is found associated with other hydrocarbon fuel, in coal beds, as methane clathrates, and is an important fuel source and a major feedstock for fertilizers.Most natural...
futures market back in September 2006. Amaranth had a concentrated, undiversified position in its natural gas strategy. The trader had used leverage to build a very large position. Amaranth’s positions were staggeringly large, representing around 10% of the global market in natural gas futures. Chincarini notes that firms need to manage liquidity risk explicitly. The inability to sell a futures contract at or near the latest quoted price is related to one’s concentration in the security. In Amaranth’s case, the concentration was far too high and there were no natural
counterparties when they needed to unwind the positions. Chincarini (2006) argues that part of the loss Amaranth incurred was due to asset illiquidity. Regression analysis on the 3 week return on natural gas future contracts from August 31, 2006 to September 21, 2006 against the excess open interest suggested that contracts whose open interest was much higher on August 31, 2006 than the historical normalized value, experienced larger negative returns.
Northern Rock - 2007
Northern RockNorthern Rock
Northern Rock plc is a British bank, best known for becoming the first bank in 150 years to suffer a bank run after having had to approach the Bank of England for a loan facility, to replace money market funding, during the credit crisis in 2007. Having failed to find a commercial buyer for...
suffered from funding liquidity risk in September 2007 following the subprime crisis. The firm suffered from liquidity issues despite being solvent at the time, because maturing loans and deposits could not be renewed in the short-term money markets . In response, the FSA
Financial Services Authority
The Financial Services Authority is a quasi-judicial body responsible for the regulation of the financial services industry in the United Kingdom. Its board is appointed by the Treasury and the organisation is structured as a company limited by guarantee and owned by the UK government. Its main...
now places greater supervisory focus on liquidity risk especially with regard to "high-impact retail firms".