Risk Capital Allocation under Market Liquidity Constraints

Abstract

We develop measures of certain kinds of liquidity trading risk that is useful for completing the definition of market risk and for predicting liquidity-adjusted VaR (L-VaR) under illiquid market conditions. We argue that asset liquidity risk associated with the uncertainty of liquidating multiple-asset portfolios over a given holding period is a key factor in the computation of a credible risk-capital allocations in financial trading units.

Keywords: Emerging Markets, Financial Engineering, Financial Risk Management, GARCH-M Model, Liquidity Risk, Optimization, Portfolio Management, Sub-prime Crisis, Value-at-Risk

JEL Classification: C10, C13, G20, and G28