Abstract
The usual measures of market risk are based on the axiom of positive homogeneity while neglecting an important element of market information—liquidity. To analyze the effects of this omission, in the present study, we define the behavior of prices and volume via stochastic processes subordinated to the time elapsing between two consecutive transactions in the market. Using simulated data and market data from companies of different sizes and capitalization levels, we compare the results of measuring risk using prices compared to using both prices and volumes. The results indicate that traditional measures of market risk behave inversely to the degree of liquidity of the asset, thereby underestimating the risk of liquid assets and overestimating the risk of less liquid assets.
Highlights
Liquidity risk is an important field of research in finance, as evidenced by the large number of papers published on this subject ([1,2,3,4,5,6,7,8,9,10,11,12,13,14,15,16])
Our objective is to develop a methodology for estimating the market risk of assets including liquidity risk, as several authors, such as those of [20], found that assets more sensitive to liquidity offer higher average returns
A market-risk estimation model that accounts for liquidity risk must incorporate the defining elements of liquidity risk ([17,21]), including the immediacy or execution time of a transaction, the rigidity or cost of liquidating a small position, the depth or ability to trade at any volume, and the resilience or speed with which prices return to their equilibrium values
Summary
Liquidity risk is an important field of research in finance, as evidenced by the large number of papers published on this subject ([1,2,3,4,5,6,7,8,9,10,11,12,13,14,15,16]). A market-risk estimation model that accounts for liquidity risk must incorporate the defining elements of liquidity risk ([17,21]), including the immediacy or execution time of a transaction, the rigidity or cost of liquidating a small position, the depth or ability to trade at any volume, and the resilience or speed with which prices return to their equilibrium values For this purpose, the authors of [22] defined risk in terms of the change in value between two dates that are known but does not consider the period necessary to liquidate a position.
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