Portfolio Liquidity Risk: A Practitioner Perspective

Abstract

Since the recent financial crisis, global institutions and governments strove for reducing both individual bank risk and systematic risks. New regulatory requirements have been proposed and then introduced in recent reforms and financial directives for the global markets. Above all, a new awareness of the importance of market liquidity as a crucial ingredient for the market functioning emerged and consequently a lot of efforts have been put in place in order to provide an unbiased measurement of its current level and to be able to obtain a reasonable forecast for the future. Even if the concept of liquidity may be well-spread among professionals, a common, largely agreed, quantitative approach within portfolio theory and risk management is still lacking, and practitioners are more inclined to consider their contingent situations with ad-hoc recipes and guidelines, rather than to follow a standardize framework based on firm ground.In this article we focus on the point of view of a fund asset manager which wants to know the actual value of her portfolio in an illiquid market and quantify her liquidity risk associated. Within Acerbi-Scandolo framework, we shall distinguish between assessing the value or pricing a portfolio and the quest of the optimal buy/sell strategy to obtain a performance benchmark in a given time horizon, which is more the domain of investment management rather than pricing.This analysis gives us the possibility to focus directly on the today assessment of the cost to bear in the case that one needs or simply wants to liquidate her position in an illiquid market, where not every position to sell can find an other at the best price. This reasoning leads us to the second part of the present paper, where we give an economically sensible estimation of the today supply-and-demand curve and quantify the bounds for the liquidity cost in very simple terms. In particular, our lower bound L is rather simple to implement and it can be used by any financial practitioner as a robust and conservative measure of the liquidity cost which takes into account both exogenous and endogenous aspects of asset liquidity risk.