Measuring Corpotate Liquidity Risk

Abstract

This article presents the outline of a framework for evaluating liquidity risk (at the corporate level) with risk measures that are intuitive and economically relevant. In particular, the risk measures are designed explicitly to show the effectiveness of a company's risk management program in helping the firm to (1) avoid financial distress or default and (2) ensure its ability to undertake all strategic investments.For managers attempting to quantify liquidity risks, this paper proposes that the risk measures have two important features: One is to make the liquidity risk estimate depend on some measure of the firm's balance sheet strength, one that reflects the role of the balance sheet as a risk buffer. The second is to provide a useful estimate of the opportunity costs associated with a given liquidity shortage—one that reflects the value of the investment opportunities that liquidity problems could jeopardize.The author illustrates the application of the proposed risk measures with an example of a company evaluating a hedging strategy designed to accompany a substantial increase in its investment budget. Using the risk measures discussed in this paper, the author shows how to assess the effectiveness of a proposed hedge in terms of its expected ability to reduce costly cash shortfalls in scenarios in which the firm's debt capacity is also expected to be depleted.