Modeling Liquidity Risk with Implications for Traditional Market Risk Measurement and Management

16 Pages Posted: 11 Nov 2008  

Anil Bangia

Oliver, Wyman & Company, LLC.

Francis X. Diebold

University of Pennsylvania - Department of Economics; National Bureau of Economic Research (NBER)

Til Schuermann

Oliver Wyman

John Stroughair

Oliver, Wyman & Company, LLC.

Date Written: May 2008

Abstract

Market risk management traditionally has focussed on the distribution of portfolio value changes resulting from moves in the midpoint of bid and ask prices. Hence the market risk is really in a "pure" form: risk in an idealized market with no "friction" in obtaining the fair price. However, many markets possess an additional liquidity component that arises from a trader not realizing the mid-price when liquidating her position, but rather the mid-price minus the bid-ask spread. We argue that liquidity risk associated with the uncertainty of the spread, particularly for thinly traded or emerging market securities under adverse market conditions, is an important part of overall risk and is therefore an important component to model.We develop a simple liquidity risk methodology that can be easily and seamlessly integrated into standard value-at-risk models, and we show that ignoring the liquidity effect can produce underestimates of market risk in emerging markets by as much as 25-30%. Furthermore, we show that the BIS inadvertently is already monitoring liquidity risk, and that by not modeling it explicitly and therefore capitalizing against it, banks will be experiencing surprisingly many violations of capital requirements, particularly if their portfolios are concentrated in emerging markets.

Suggested Citation

Bangia, Anil and Diebold, Francis X. and Schuermann, Til and Stroughair, John, Modeling Liquidity Risk with Implications for Traditional Market Risk Measurement and Management (May 2008). NYU Working Paper No. FIN-99-062. Available at SSRN: https://ssrn.com/abstract=1298788

Anil Bangia (Contact Author)

Oliver, Wyman & Company, LLC.

666 Fifth Ave.
New York, NY 10103
United States

Francis X. Diebold

University of Pennsylvania - Department of Economics ( email )

160 McNeil Building
3718 Locust Walk
Philadelphia, PA 19104
United States
215-898-1507 (Phone)
215-573-4217 (Fax)

HOME PAGE: http://www.ssc.upenn.edu/~fdiebold/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Til Schuermann

Oliver Wyman ( email )

1166 6th Avenue
New York City, NY
United States

John Stroughair

Oliver, Wyman & Company, LLC.

666 Fifth Ave.
New York, NY 10103
United States

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