Liquidity Risk

Introduction
Liquidity risk came into limelight during the credit crisis of 2007
Financial institutions faced funding problems as lenders were unwilling to roll
over their loans
At the same time, these institutions found it difficult to sell their assets to
generate liquidity
◦ Financial institutions found that some instruments for which there had previously
been a liquid market could only be sold at fire-sale prices during the crisis
Even though they were solvent having more assets than liabilities, they faced
failure due to lack of liquidity (Solvency vs Liquidity)
◦ Liquidity refers to the ability of a company to make cash payments as they become
due.
Introduction
Liquidity risk is closely associated with other financial risks such as market risk
and credit risk
◦ Management of market and credit risk requires making adjustments to market and
credit risk exposure
◦ These adjustments require existence of a liquid market for easy sale and purchase of
assets
◦ Liquidity is an important consideration in trading. A liquid position in an asset is one
that can be unwound at short notice
◦ As the market for an asset becomes less liquid, traders are more likely to take losses
because they face bigger bid–offer spreads
◦ For an option or other derivative, it is important for there to be a liquid market for
the underlying asset so that the trader has no difficulty in doing the daily trades
necessary to maintain delta neutrality
Introduction
Liquidity in the markets keeps on varying. It becomes very tight in times of
market crisis
◦ In times of market crisis, there is a flight to quality that represents increasing demand
for high-rated securities
◦ The market for low-rated securities becomes less liquid during such times
Introduction
It is important for financial institutions to manage liquidity carefully.
◦ Liquidity needs are uncertain.
◦ A financial institution should assess a worst-case liquidity scenario and make sure
that it can survive that scenario by either converting assets into cash or raising cash
in some other way.
Types of Liquidity Risk
Liquidity risk is of two types:
Asset liquidity risk: Risk of adverse movement in the price of an asset when it is
bought or sold
Funding liquidity risk: Funding liquidity risk is the risk that the firm will not be
able to meet efficiently both expected and unexpected current and future cash
flow and collateral needs without affecting either daily operations or the
financial condition of the firm.
Asset Liquidity Risk
A low asset liquidity risk means that the asset can be liquidated or a short
position in the asset can be covered quickly, cheaply, and without much
movement in the price
Asset liquidity risk arises due to difficulty in finding a counterparty, particularly
in stressful market conditions
Asset Liquidity Risk
Asset liquidity can be described in terms of three characteristics:
Tightness:
◦ Related to transaction cost involved in liquidating an asset
◦ Usually measured by the bid-ask spread and brokers’ commissions
Depth
◦ Related to the size of an order that can move the market adversely or
◦ The number of units that can be sold or bought by traders at the current price
without moving the price
◦ Asset liquidity risk arises due to lack of depth in the market for an asset
Resiliency
◦ Related to the length of time for which the market stays away from the equilibrium
price as a result of a large order
Asset Liquidity Risk
Asset liquidity risk arises due to lack of depth in the market for an asset
In such a market, a position cannot be easily unwound at short notice at a
reasonable cost
Asset liquidity risk can be assessed by looking at the transaction cost involved in
liquidating an asset
The transaction cost is measured by the bid-ask spread which represents the
cost of a round-trip normal-size transaction of buying and selling an asset
Ask (bid) price is the price at which the market maker is willing to sell (buy)
Bid-Ask Spread
Compensates dealers in the market for holding inventories of assets so that
transactions can be executed quickly
Bid-Ask Spread
𝐴𝑏𝑠𝑜𝑙𝑢𝑡𝑒 𝑇𝑒𝑟𝑚𝑠: 𝑝 = 𝐴𝑠𝑘 𝑃𝑟𝑖𝑐𝑒 − 𝐵𝑖𝑑 𝑃𝑟𝑖𝑐𝑒

𝐴𝑠𝑘 𝑃𝑟𝑖𝑐𝑒 −𝐵𝑖𝑑 𝑃𝑟𝑖𝑐𝑒

𝑅𝑒𝑙𝑎𝑡𝑖𝑣𝑒 𝑇𝑒𝑟𝑚𝑠: 𝑠 =
𝑀𝑖𝑑−𝑚𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒

Mid-market Price = (Ask Price + Bid Price)/2 Further Reading

Further Reading
Funding Liquidity Risk
Funding liquidity risk arises when an obligor is unable to honor its obligation of
payment to its creditors or investors
Liquidity funding problems at a financial institution can be caused by:
1. Liquidity stresses in the economy (e.g., a flight to quality such as that seen
during the 2007 to 2009 crisis). Investors are then reluctant to provide funding in
situations where there is any credit risk at all.
2. Overly aggressive funding decisions. There is a tendency for all financial
institutions to use short-term instruments to fund long-term needs, creating a
liquidity mismatch. Financial institutions need to ask themselves: “How much of
a mismatch is too much?”
3. A poor financial performance, leading to a lack of confidence. This can result
in a loss of deposits and difficulties in rolling over funding.
Funding Liquidity Risk
Often, when a company experiences severe liquidity problems, all three of these
have occurred at the same time.
The key to managing liquidity risk is predicting cash needs and ensuring that
they can be met in adverse scenarios.
Some cash needs are predictable. For example, if a bank has issued a bond, it
knows when coupons will have to be paid.
Others, such as those associated with withdrawals of deposits by retail
customers and drawdowns by corporations on lines of credit that the bank has
granted, are less predictable.
Downgrade triggers, guarantees provided by a financial institution, and possible
defaults by counterparties in derivatives transactions can have an unexpected
impact on cash resources.
Funding Liquidity Risk
Funding liquidity risk can take different forms:
Rollover Risk: Rollover risk arises when the intermediary is not able to refinance
the short-term debt or refinance is available at highly unfavourable terms
◦ Financial institutions generally face funding liquidity risk when there is a maturity
mismatch between assets and liabilities
◦ A maturity mismatch arises when a longer-term asset is funded with a shorter-term
liability
◦ Banks and other financial intermediaries borrow short-term to invest in long-term
assets
◦ They do so because they find it profitable – short-term debt instruments have a
much lower cost compared to the return on long-term investments [because yield
curve generally slope upwards]
Funding Liquidity Risk
Margin Funding Risk
◦ When traders do not have enough funds to meet margin calls on their outstanding
market positions
◦ Most trading positions in the market are leveraged – traders may borrow a part of
the cost of the asset from the broker
◦ The ratio of the trader’s equity in the asset to the value of the asset is called the
margin
◦ The broker stipulates a minimum margin to be maintained at all times
Measuring Funding Liquidity Risk
Measurement of funding liquidity risk is part of the traditional asset-liability
management (ALM) function in banks
ALM prepares a forecast of both sources and uses of cash and cash equivalents
to take either funding or investing decisions
Some ratios such as loans to deposits ratio, borrowed funds to total assets ratio,
lending commitments to assets ratio, etc. can be used to identify the need to
mobilize more deposits or to plan for raising funds
Managing Liquidity Risk
Purchasing and storing liquidity
◦ Purchasing: from central bank/other banks/issuing instruments like bonds
◦ Purchasing involves payment of interest
◦ Storing: keeping highly liquid assets/keeping cash reserves with central bank
◦ Storage involves opportunity cost of foregoing interest on investment
Adequate capital
◦ Funding liquidity risk can be controlled by maintaining adequate capital
Managing Liquidity Risk
Funding programs:
◦ Should not raise large amounts of funds in times of crises or in short period
◦ Should plan the funding: long maturity, stable sources, sufficient cushion of unused
credit
◦ Should have a contingency plan for managing a funding crisis (identify assets that can
be sold easily/derivative positions that can be liquidated at short notice/untapped
sources of funding)
◦ Overreliance on a specific source of fund should be avoided
Managing Liquidity Risk
Debt-equity Ratio:
◦ Maintain an optimal mix (advantages vs disadvantages)
◦ Very high proportion of debt in the capital structure makes the firm risky making it
difficult for the firm to raise additional capital at reasonable cost
Working Capital Management:
◦ Too much should not be tied up in inventories and receivables
◦ Make use of working capital management software
◦ Keep working capital ratios in desired ranges
Further Reading
Asset Liquidity
The price at which a particular asset can be sold depends on:
1. The mid-market price of the asset, or an estimate of its value
2. How much of the asset is to be sold
3. How quickly it is to be sold
4. The economic environment
Asset Liquidity
When there is a market maker who quotes a bid and offer price for a financial
asset, the financial institution can sell the asset at the bid and buy at the offer.
When there is no market maker for a financial instrument, there is still an
implicit bid–offer spread. If a financial institution approaches another financial
institution to do a trade, the price depends on which side of the trade it wants
to take.
The general nature of the relationship between bid quotes, offer quotes, and
trade size is: the bid price tends to decrease and the offer price tends to
increase with the size of a trade.
For an instrument where there is a market maker, the bids and offers are the
same up to the market maker’s size limit and then start to diverge.
Asset Liquidity (Figure 24.1)
Asset Liquidity
Figure 24.1 describes the market for large deals between sophisticated financial
institutions.
The bid–offer spreads in the retail market sometimes show the opposite pattern
to that in Figure 24.1.
For example: An individual approaches a branch of a bank wanting to do a
foreign exchange transaction or invest money for 90 days. As the size of the
transaction increases, the individual is likely to get a better quote.
Asset Liquidity
The price that can be realized for an asset often depends on how quickly it is to
be liquidated and the economic environment.
Sometimes liquidity is tight. Liquidating even a relatively small position can then
be time-consuming and is sometimes impossible.
On other occasions, there is plenty of liquidity in the market and relatively large
positions can be unwound without difficulty.
Asset Liquidity
Liquidating a large position can be affected by what is termed predatory trading.
This occurs when a market participant, say Company X, has a large position and
other market participants guess that it will have to be unwound in the near
future.
The other market participants attempt to profit by doing similar trades to those
they expect from Company X.
For example, if it is expected that Company X will have to sell a large position in
a particular stock, they short the stock in anticipation of a price decline.
This makes it more difficult than it would otherwise be for Company X to exit
from its position at competitive prices.
To avoid predatory trading, financial institutions emphasize to employees the
importance of keeping their positions and their future trading plans confidential.
Liquidity Black Hole
Another problem in the market for financial assets is that, when one financial
institution finds that it needs to unwind a position, it is often the case that many
other financial institutions with similar positions need to do the same thing.
The liquidity normally present in the market then evaporates.
This is the “liquidity black hole” phenomenon.
A liquidity black hole describes a situation where liquidity has dried up in a
particular market because everyone wants to sell and no one wants to buy, or
vice versa. It is sometimes also referred to as a “crowded exit.”
These are situations where almost everyone wants to do the same type of trade
at the same time.
Liquidity Black Hole
In a well-functioning market, the market may change its opinion about the price
of an asset because of new information.
However, the price does not overreact.
If a price decrease is too great, traders will quickly move in and buy the asset
and a new equilibrium price will be established.
A liquidity black hole is created when a price decline causes more market
participants to want to sell, driving prices well below where they will eventually
settle.
During the sell-off, liquidity dries up and the asset can be sold only at a fire-sale
price.
Bid-Ask Spread
The dollar bid–offer spread is:

The proportional bid–offer spread is:

Bid-Ask Spread
Suppose that a financial institution has bought 10 million shares of one company
and 50 million ounces of a commodity.
The shares are bid $89.5, offer $90.5. The commodity is bid $15, offer $15.1.
Trades are not done at the mid-market price.
A buy trade is done at the offer price and a sell trade is done at the bid price.
The transaction cost is measured by the bid-ask spread which represents the
cost of a round-trip normal-size transaction of buying and selling an asset.
Bid-Ask Spread
The round-trip transaction cost:
Shares: Buy 10mn shares @ $90.5 – Sell 10mn shares @ $89.5 = 10mn
Commodity: Buy 50mn ounces @ $15.1 – Sell 50mn ounces @ $15 = 5mn
Total round-trip transaction cost = 10mn + 5mn = $15mn
Average cost of one leg of transaction (either buy or sell) = 15mn/2 = $7.5mn
Bid-Ask Spread
𝐴𝑠𝑘−𝐵𝑖𝑑 ∗𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑙𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑜𝑛 =
2

𝐴𝑠𝑘+𝐵𝑖𝑑
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑦𝑖𝑛𝑔 𝑛𝑢𝑚𝑒𝑟𝑎𝑡𝑜𝑟 𝑎𝑛𝑑 𝑑𝑒𝑛𝑜𝑚𝑖𝑛𝑎𝑡𝑜𝑟 𝑏𝑦 ( )
2

𝐴𝑠𝑘+𝐵𝑖𝑑
𝐴𝑠𝑘−𝐵𝑖𝑑 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 ∗
2
= 𝐴𝑠𝑘+𝐵𝑖𝑑 ∗
2
2

𝑅𝑒𝑙𝑎𝑡𝑖𝑣𝑒 𝑏𝑖𝑑−𝑎𝑠𝑘 𝑠𝑝𝑟𝑒𝑎𝑑∗𝑆𝑖𝑧𝑒 𝑚𝑖𝑑−𝑚𝑎𝑟𝑘𝑒𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑜𝑠𝑖𝑡𝑖𝑜𝑛

=
2
Bid-Ask Spread
An investor has ₹20 million invested in a 20-year Treasury bond.
The relative spread on the bond is 0.15%
The cost of liquidating the position is:
=(20mn*0.15%)/2
= ₹15,000

Back
Liquidity-Adjusted VaR
Some researchers have suggested combining market VaR and liquidity risk
measure into a liquidity-adjusted VaR measure
Liquidity-adjusted VaR = Regular VaR + cost of unwinding position
Sources of Liquidity
The main sources of liquidity for a financial institution are:
Holdings of cash and Treasury securities
◦ Relatively expensive
◦ Trade-off between the liquidity and the return it provides
◦ Therefore, held within a reasonable limit
The ability to liquidate trading book positions
◦ Important for a financial institution to quantify the liquidity of its trading book so that
it knows how easy it would be to use the book to raise cash.
◦ Analysis should be based on stressed market conditions, not normal market
conditions
Sources of Liquidity
The ability to borrow money at short notice
◦ In stressed market conditions there are higher interest rates, shorter maturities for
loans, and in some cases a refusal to provide funds
◦ Financial institutions should monitor the assets that can be pledged as collateral for
loans at short notice
◦ Can (at a cost) mitigate funding risks somewhat by arranging lines of credit
Sources of Liquidity
The ability to offer favorable terms to attract retail and wholesale deposits at
short notice:
◦ Wholesale deposits are a more volatile source of funding than retail deposits and can
disappear quickly in stressed market conditions.
◦ Even retail deposits are not as stable as they used to be because it is very easy to
compare interest rates offered by different financial institutions and make transfers
via the Internet.
◦ When one financial institution wants to increase its retail or wholesale deposit base
for liquidity reasons by offering more attractive rates of interest, others usually want
to do the same and the increased funding is likely to be difficult to achieve.
Sources of Liquidity
The ability to securitize assets (such as loans) at short notice:
◦ Rather than keep illiquid assets such as loans on their balance sheet, banks have
securitized them.
◦ Prior to August 2007, securitization was an important source of liquidity for banks.
◦ However, this source of liquidity dried up almost overnight in August 2007 as
investors decided that the securitized products were too risky.
Borrowings from the central bank
◦ Often referred to as “lenders of last resort.”
◦ When commercial banks are experiencing financial difficulties, central banks are
prepared to lend money to maintain the health of the financial system
Relation between Asset Liquidity Risk and
Funding Liquidity Risk
Asset liquidity risk and funding liquidity risk are related
Funding liquidity risk arises when, due to the perception of a threat to a firm’s
existence, its creditors or investors start demanding their money back
To meet this funding liquidity risk, the firm may have to resort to a forced
liquidation of its assets at distress prices giving rise to asset liquidity risk
Similarly, if a party carries assets which are perceived to be illiquid, the party will
certainly face the funding liquidity risk