Liquidity Risk Measures Research Articles

Liquidity and Credit Default Swap Spreads

We present an empirical study of the pricing effect of liquidity in the credit default swaps (CDS) market. We construct liquidity proxies to capture various facets of CDS liquidity including adverse selection, search frictions, and inventory costs. We show that the liquidity effect on CDS spreads is significant with an estimated liquidity premium on par with those of Treasury bonds and corporate bonds. Our finding of cross-sectional variations in the liquidity effect highlights the structure of the search-based over-the-counter market and the interplay between search friction and adverse selection in CDS trading. Using liquidity betas and volume respectively to measure liquidity risk, we find supporting evidence for liquidity risk being priced beyond liquidity level in the CDS market.

Execution Risk

Transaction costs in trading involve both risk and return. Risk is a result of price movements and price impacts over a gradual trading period. Return is associated with the cost of immediate execution. The trade-off between risk and return in optimal execution reflects the same risk preferences as in ordinary investment. Models of the joint optimization of positions and trades show conditions under which optimal execution does not depend on the other holdings in the portfolio. Optimal execution, however, may call for trades in assets other than those listed in the trading order; these can hedge the trading risks. The execution risk model for trading with reversals and continuations implies a natural measure of liquidity risk. <b>TOPICS:</b>Risk management, statistical methods

Execution Risk

Transaction costs in trading involve both risk and return. Risk is a result of price movements and price impacts over a gradual trading period. Return is associated with the cost of immediate execution. The trade-off between risk and return in optimal execution reflects the same risk preferences as in ordinary investment. Models of the joint optimization of positions and trades show conditions under which optimal execution does not depend on the other holdings in the portfolio. Optimal execution, however, may call for trades in assets other than those listed in the trading order; these can hedge the trading risks. The execution risk model for trading with reversals and continuations implies a natural measure of liquidity risk. <b>TOPICS:</b>Risk management, exchanges/markets/clearinghouses

Liquidity Risk and Correlation Risk: A Clinical Study of the General Motors and Ford Downgrade of May 2005

The GM and Ford downgrade to junk status during May 2005 caused a wide-spread sell-off in their corporate bonds. Using a novel dataset, we document that this sell-off appears to have generated significant liquidity risk for market-makers, as evidenced in the significant imbalance in their quotes towards sales. We also document that simultaneously, there was excess co-movement in the fixed-income securities of all industries, not just in those of auto firms. In particular, using credit-default swaps (CDS) data, we find a substantial increase in the co-movement between innovations in the CDS spreads of GM and Ford and those of firms in all other industries, the increase being greatest during the period surrounding the actual downgrade and reversing sharply thereafter. We show that a measure of liquidity risk faced by corporate bond market-makers – specifically, the imbalance towards sales in the volume and frequency of quotes on GM and Ford bonds – explains a significant portion of this excess co-movement. Additional robustness checks suggest that this relationship between the liquidity risk faced by market-makers and the correlation risk for other securities in which they make markets was likely causal. Overall, the evidence is supportive of theoretical models which imply that funding liquidity risk faced by financial intermediaries is a determinant of market prices during stress times.

A Primer for Risk Measurement of Bonded Debt from the Perspective of a Sovereign Debt Manager

This paper presents some conventional and new measures of market, credit, and liquidity risks for government bonds. These measures are analyzed from the perspective of a sovereign's debt manager. In particular, it examines duration, convexity, M-square, skewness, kurtosis, and VaR statistics as measures of interest rate exposure; a VaR statistic as the prominent measure of exchange rate exposure; the balance sheet approach (or contingent claims approach), and its consequent probability of default as the most promising measure of credit risk exposure; and an elasticity approach and a VaR statistic to measure liquidity risk. Along with the formulas for the various statistics proposed, we provide simple examples of their application to some common risk valuation cases. Finally, we present an integrated approach for the simultaneous estimation of a portfolio's interest rate and exchange rate risk using the VaR methodology. The integrated approach is then extended to also include N risk factors. This approach allows us to measure the total risk of a portfolio, provided that the volatilities and correlations among the risk factors can be estimated.

A Primer for Risk Measurement of Bonded Debt From the Perspective of a Sovereign Debt Manager

This paper presents some conventional and new measures of market, credit, and liquidity risks for government bonds. These measures are analyzed from the perspective of a sovereign's debt manager. In particular, it examines duration, convexity, M-square, skewness, kurtosis, and VaR statistics as measures of interest rate exposure; a VaR statistic as the prominent measure of exchange rate exposure; the balance sheet approach (or contingent claims approach), and its consequent probability of default as the most promising measure of credit risk exposure; and an elasticity approach and a VaR statistic to measure liquidity risk. Along with the formulas for the various statistics proposed, we provide simple examples of their application to some common risk valuation cases. Finally, we present an integrated approach for the simultaneous estimation of a portfolio's interest rate and exchange rate risk using the VaR methodology. The integrated approach is then extended to also include N risk factors. This approach allows us to measure the total risk of a portfolio, provided that the volatilities and correlations among the risk factors can be estimated.

How Large is Liquidity Risk in an Automated Auction Market?

We introduce a new empirical methodology that takes account of liquidity risk in a Value-at-Risk framework, and quantify liquidity risk premiums for portfolios and individual stocks traded on the automated auction market Xetra which operates at various European exchanges. When constructing liquidity risk measures we allow for the potential price impact incurred by the liquidation of a portfolio. We study the sensitivity of liquidity risk towards portfolio size and VaR time horizon, and interpret its diurnal variation in the light of market microstructure theory.

Alpha Transfer in a Hedge Fund World: Fact or Fantasy

Because of the implicit assumptions involved in attempting to transfer alpha from hedge funds to fixed-income portfolios, investors must be aware that risks get transferred along with returns. The kind of alpha at play is a random variable, not a number that can be extrapolated based on historical patterns. Three important areas for future development are identified: new risk models for hedge fund investments (particularly the ability to measure liquidity risk), the relative efficiency of alpha transfer mechanisms, and the ability to model investment cycles.

MEASURES OF LIQUIDITY RISK SUPPLEMENTING FUZZY DISCOUNTED CASH FLOW ANALYSIS

ABSTRACT Fuzzy discounted cash flow (DCF) techniques have been used to cope with the problems encountered by the deterministic or probabilistic evaluation of the investment alternatives. However, especially when a superior alternative cannot be spotted as a result of the DCF analysis, these techniques require a supplement such as the payback method or the duration analysis to assess liquidity risk. In this paper, 1 present fuzzy analogues of the payback method (conventional and discounted), which is a frequently used measure of liquidity risk in capital budgeting. Next, for investment projects, 1 propose a fuzzy economic evaluation criterion based on (he duration measure, which incorporates liquidity risk in capital investment while overcoming the obvious shortcomings of the payback method. Then, via a numerical example, I illustrate how to use the fuzzy payback method and fuzzy duration analysis as secondary decision criteria to rank investment alternatives, for which preference cannot be expressed in terms of fuzzy present worths.

Determinants of Risk Premiums on Corporate Bonds

ECONOMISTS have long agreed that the rate of interest on a loan depends on the risks the lender incurs. But how lenders estimate these risks has been left largely to conjecture. This paper presents and tests a hypothesis about the determinants of risk premiums on corporate bonds. By risk premium is meant the difference between the market yield on a bond and the corresponding pure rate of interest. My hypothesis is as follows: (1) The average risk premium on a firm's bonds depends first on the risk that the firm will default on its bonds and second on their marketability. (2) The "risk of default" can be estimated by a function of three variables: the coefficient of variation of the firm's net income over the last