Abstract
Liquidity risk is divided into asset liquidity risk and funding liquidity risk. The first one, known as market/product-liquidity risk arises when a forced liquidation of assets creates unfavorable price movements. This risk varies across categories of assets and across time as a function of prevailing market conditions. It can be managed by setting limits on certain markets or products and by means of diversification. Liquidity risk can be factored into VaR measures by ensuring the horizon is at least greater than an orderly liquidation period.
Highlights
The process of assessing asset liquidity risk starts with focusing on the various components of liquidation costs
A simple way to measure the cost of liquidating a position in an asset in a normal market conditions, is to consider the cost equal
Where n is the number of positions, αi is the position in the ith instrument, and
Summary
The process of assessing asset liquidity risk starts with focusing on the various components of liquidation costs. Spreads vary from a low of about 0.05% for major currencies, large US stocks, and on-the-run Treasuries to much higher values when dealing with less liquid currencies, stocks, and bonds. Spreads reflect three different types of costs according to market microstructure theory: order-processing costs, asymmetric-information costs, and inventory carrying costs. A simple way to measure the cost of liquidating a position in an asset in a normal market conditions, is to consider the cost equal
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