The Role of Liquidity in Value at Risk - The Case of Hong Kong
45 Pages Posted: 24 Aug 2007
Date Written: August 2007
Abstract
This paper extends the conventional Value at Risk (VaR) to incorporate liquidity in intraday time horizon. Our rationale is that the Liquidity Adjusted Intraday VaR (L-VaR) is particularly relevant to day traders who are more interested in intraday market movement that could not be simply represented by a single VaR figure generated from interday data, and whose activities are done in volatile markets where being able to trade promptly is particularly important. Using intraday stock market data in Hong Kong, we show that liquidity can constitute on average 30% of the VaR for small-price stocks. Furthermore, it will be relatively less risky, both in terms of L-VaR and VaR, for day traders to trade in the middle of the trading days. Furthermore, given the importance of derivative securities nowadays, we conjecture that if liquidity is an important component in VaR for stocks, it will also assert significant impact of the derivatives counterpart. We therefore extend the study to highlight this importance by comparing the structure of the bid/ask spread of the Hong Kong options and stock market. We also provide explanation for wider spreads in option markets given different levels of moneyness and time to maturity.
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