Handbook of Asset and Liability Management: From models to optimal return strategies

19

Financial Risks

Qui ne risque rien n'a rien.

19.1 LIQUIDITY RISK

Liquidity risk is a difficult issue in risk management. Many definitions may be provided for this risk and very few mathematical risk analyses exist especially in the regulatory environment.

This chapter will try to define the most interesting part of liquidity risk, i.e. how to manage it and how to represent it.

19.1.1 Nature of liquidity risk and examples

When talking about liquidity risk, the A/L manager will distinguish between illiquidity risk and company liquidity risk.

Illiquidity risk is the risk of not being able to sell, on a short-term horizon, an asset (such as a bond, a stock, etc.) at a reasonable market price. Illiquidity comes from the rarity of the asset, the market low level of development, the complexity of the asset, etc.

For example, it could take time to sell a long-term bond with a coupon indexed to a non-interest rate index (such as a non-liquid stock index) issued by a non investment grade company.

Illiquidity has a market price. The bond coupon in our example should include a premium for possible illiquidity. As long as the bondholder keeps the bond, he gets the premium.

However, for A/L managers, company liquidity risk is the most important.

Liquidity management is the company's ability:

• to provide to business lines funding at a reasonable cost; and
• to meet company liabilities on a short, medium and long-term horizon.

The ability to provide funding at a reasonable cost means the ...