Chapter 37

Liquidity Analysis and Management

Examples from the Credit Crisis

In Chapter 36, we applied the Jarrow-Merton put option concept as a comprehensive measure of integrated interest rate, market risk, foreign exchange risk, and credit risk. We listed four key questions and 26 supplementary questions that can be answered as a result of the risk management process that are outlined in the first 36 chapters of this book. We reviewed the observable market data on the cost of the Jarrow-Merton put option for Citigroup at various time horizons. Finally, we showed the multiperiod simulation process that allows us to value the Jarrow-Merton put option, giving us an alternative measure of the dollar amount of money that would be necessary to eliminate the risk we face. We also noted in that chapter that the put option concept can be applied to risk management defined as shortfalls in net income, capital ratios, or provisions for loan losses.

In this chapter, we apply the same concept to shortfalls in cash—liquidity risk—which is tightly linked with the credit risk of the institution. We take great care to avoid the single greatest mistake in liquidity risk analysis—basing the analysis solely on the cash flow history of a firm that has never had a “near death” experience from liquidity risk. Indeed, our focus in this chapter is primarily on institutions that have had such near death experiences. We start with a review of the five biggest liquidity risk problems in North America during ...

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