Handbook of Market Risk

Chapter Ten

Liquidity Risk

Liquidity is an elusive notion. Three basic definitions are commonly used: (1) the liquidity of financial instruments reflects the ease with which they can be exchanged for money without loss of value; (2) a related concept is market liquidity defined as the market's ability to trade a given volume of assets or securities without significantly affecting their prices; and (3) finally, monetary liquidity pertains to the quantity of fully liquid assets circulating in the economy. It is usually measured by a narrow or broad monetary aggregate or its ratio to nominal GDP. In this section we will focus on definitions 1 and 2. Liquidity risk in the context of banking will be covered in the chapter on Basel II/III (Chapter 13).

We have to distinguish between the risk to funding the firm, which is usually referred to as “funding liquidity risk,” and the risk that a particular on- or off-balance sheet market or product is illiquid, which is referred to as “market liquidity risk.” The management of “funding liquidity risk” is the risk that the firm will not be able to efficiently meet both expected and unexpected current and future cash flow and collateral needs without affecting daily operations or the financial condition of the firm.” Market liquidity risk is defined as the risk that a firm cannot easily offset or eliminate a position without significantly affecting the market price because of inadequate market depth or market disruption. In this book, we will ...