Encyclopedia of Financial Models III

Estimating Liquidity Risks

KEVIN DOWD, PhD

Partner, Cobden Partners, London

Abstract: The measurement of liquidity risk risks is an underdeveloped area of market risk measurement and management. Liquidity issues affect the estimation of conventional market risk measures, but the measurement of liquidity risks is an important subject in its own right. Liquidity issues also figure prominently in periods of market crisis. There are various easily implementable and often complementary approaches to the estimation of liquidity-adjusted Value-at-Risk: These involve modeling the bid-ask spread or the liquidity discount incurred when liquidating a position. There are also approaches to the modelling of Liquidity-at-Risk, which deals with the riskiness of cash flows, in both noncrisis and crisis situations.

Market practitioners often assume that markets are liquid—that is, that we can liquidate or unwind positions at going market prices, usually taken to be the mean of bid and ask prices, without too much difficulty or cost. This assumption is very convenient and provides a justification for the practice of marking positions to market prices. However, it is often empirically questionable and the failure to allow for it can seriously undermine market risk measurement. In any case, liquidity risk is a major risk factor in its own right, and we will often want to measure it too.

This entry looks at liquidity issues and how they affect the estimation of market and liquidity risk measures. ...