Cash Liquidity at Risk
International Review of Applied Financial Issues and Economics, Vol. 4(1), (2012)
Posted: 28 Mar 2013
Date Written: March 25, 2012
The measurement of firms funding liquidity risk is in general complex. In particular, liquidity insolvency happens the first time the firm cannot generate sufficient counterbalancing capacity from the liquidity hedging portfolio to cover the funding gap. The complexity arises from the fact that there is uncertainty in the creation of counterbalancing capacity from the firms liquidity hedging portfolio. This means that liquidity solvency at T>t does not guarantee solvency at t. This paper introduces, under a cash liquidity hedging capacity, a simple, monotonic, measure of liquidity risk. With a cash hedging capacity we can consistently measure the firms liquidity insolvency probability α at horizon T using Value at Risk for horizon T. The Value at Risk measure, used in this context, is denoted Cash Liquidity at Risk. Cash Liquidity at Risk is not only a single, monotonic, risk measure for a given liquidity horizon, T. It is also consistent with the regulatory liquidity coverage ratio that banks are required to report under Basel III. Therefore, it provides a valid base for a firms liquidity risk cost and benefit allocation. We demonstrate that the Cash Liquidity at Risk measure can be allocated and used to price the opportunity cost of holding contingency liquidity onto liquidity consumers and suppliers. Cash Liquidity at Risk give opportunity to allocate the liquidity contingency need top down to contingency liquidity consumers and suppliers, taking into account portfolio effects, as is best practice for market and credit risk. The measurement of liquidity risk through the monotonic Cash Liquidity at Risk measure also allows firms to put the aggregation of liquidity risk into the general framework for firmwide risk aggregation with e.g., market and credit risks.
Keywords: Liquidity risk, liquidity hedging, cash liquidity, counterbalancing capacity
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