CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

28.4 MEASURING LIQUIDITY RISKS

As a part of the risk-management process, a fund manager needs to estimate the fund's ability to survive the sudden liquidation of positions. To do so, the risk manager must understand the concentration of positions as well as the size of positions, in each market, that would be expensive and time-consuming to liquidate. This is critical, as the inability to liquidate positions caused the Long-Term Capital Management crisis in 1998 and is widely believed to have been the major cause of the Amaranth and MotherRock debacles in 2006. For a trader with a large concentrated position, a market impact cost is incurred in order to unwind.

Market impact cost is the percentage loss incurred by a portfolio during the unwinding of a large position. The analysis in Exhibit 28.7 uses five-minute interval data to calculate the coefficient of price changes for unusually large volumes on a NYMEX Henry Hub Natural Gas Prompt contract. This scenario assumes a regression on five-minute interval price and volume data, and shows that unwinding a large order (defined as an order size equal to two times the standard deviation of the usual volume for each five-minute interval) could incur a 0.00025% impact cost. In other words, assuming the fund has a position of 5,000 open contracts, a cost of nearly $5 million would be incurred to unwind this position.

EXHIBIT 28.7 Impact Cost Calculation

Source: Data from Globex.

Number of contracts	5,000
Total MMBtu	50,000,000