12.1 Liquidity Risk—Asset versus Funding Liquidity

When we turn to liquidity risk, we find that there are actually two quite distinct concepts. First there is asset liquidity risk (also known as market or product liquidity). This “arises when a forced liquidation of assets creates unfavorable price movements” (Jorion 2007, 333). The second is funding liquidity risk (also known as cash-flow liquidity). This “arises when financing cannot be maintained owing to creditor or investor demands” (Jorion 2007, 333); funding liquidity risk can also be thought of as a maturity mismatch between assets and liabilities.

Although asset and funding liquidity go by the same name, they are fundamentally different, and it is truly unfortunate that they are both called liquidity. They are related in the sense that when funding liquidity becomes an issue, then asset liquidity is invariably important. But this is no different from, say, market risk and asset liquidity risk; when there are big market movements we may need to rebalance the portfolio, and then asset liquidity becomes important and possibly contributes to further market losses.

Although going by the same name, the sources of asset and funding liquidity risks, the methods of analysis, the responses and management of the two, are so different that it I think it is more fruitful to treat them as distinct. At the end, we can return to examine the connections between them. In fact, these connections will be easier to understand after we have ...

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