Market Liquidity Risk -
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What is Market Liquidity Risk?

Market Liquidity Risk refers to the risk of losing money when you suddenly liquidate one or more positions in your portfolio. The loss comes from selling the positions at a lower price than the one at which those positions are marked-to-market.

The Liquidity Risk Paradox

While innovations in the area of market risk have been very active in recent years (introducing the concept of VaR and extending its reach) little exists on market liquidity risk. The reason is that while measuring market risk you can create models that are calibrated with market data, you cannot do the same for liquidity risk. In calibrating a liquidity risk model you need access to the bid, ask and volume information. Well, the paradox is that this information is only available for liquid issues. Bid, ask and volumes are present if the instrument shows a certain degree of liquidity. Therefore if the instrument is illiquid you will not have any information.

The paradox is that whatever model you invent, you will always lack the basic information to calibrate it for the instruments that present most of your liquidity risk. We call this the 'liquidity risk paradox'.

The bid, ask and volumes-based approaches face two additional problems:

the recent proliferation of equity market venues and the emergence of successful multi-lateral facilities (MTF) has dispersed the information on stock volumes. The MTFs are free to report the trades in the way they prefer, for example, a simple publication on a web page would suffice.
In the fixed income market the highest level of liquidity remains inside the OTC market, meaning that information on volumes available in trading platforms may not be relevant when comparing the volumes to the OTC market.

The StatPro Approach

StatPro has designed an innovative approach to measuring market liquidity risk that does not rely on observed bid, ask and volumes. The approach breaks down liquidity risk into five components:

Fair Value Bid and Fair Value Ask
Pricing Function Type
Outstanding Nominal
Market Cap (Equity Component)
Percentage of Ownership (Equity Component)

Benefits of our Liquidity Risk Module

Universal Approach
The StatPro approach is extended to any instrument, from simple equities to liquid and illiquid fixed income instruments, from certificates to complex OTC derivatives, touching all the 250+ pricing functions supported by our risk management operation.

Consistency
The approach is consistent among all asset classes, capturing all the relevant drivers of liquidity risk. For example, longer maturity will always determine higher liquidity risk. A worse credit merit will always determine more liquidity risk. The currency denomination will also be a driver of that risk and a THB bond will always present higher liquidity risk than an equivalent USD bond.

Empowering the Risk Manager
The model approach provides risk managers with a tool for spotting the main elements of liquidity risk with ease, enabling them to understand in detail the nature of liquidity risk in a portfolio without knowing the details of that portfolio.

Based on Scenarios
The system supports several scenarios of liquidity risk, giving the possibility of measuring this risk under Normal Market Conditions, Stressed Conditions and Highly Stressed Conditions.

To learn more about our Liquidity Risk module contact us today!