Risk Valuation for Securities with Limited Liquidity

Abstract

Professional market participants have to deal with illiquid securities on a constant basis. For such securities traditional risk assessment techniques fail. This can lead to underestimated and distorted results for the entire investment portfolio, and ultimately to inadequate risk management. We present a framework, based on coupled-wave model, that allows to model securities with low liquidity and evaluate impact of various risk sources, associated with liquidity. In addition to risk management, this framework should be helpful to firms and trading desks in evaluating cost of liquidity and selecting liquidation tactics for their oversize positions.

Keywords: Market making, price measurement, quantitative trading, volatility, bid-ask spread, finance, physics of financial markets, risk management

JEL Classification: C00, C01, C02, C22, C51, C58, G01