Quantitative Risk Management: A Practical Guide to Financial Risk, + Website

12.2 Asset Liquidity Risk

When we turn to asset liquidity risk, the central question is: What might the P&L be when we alter the portfolio? Most importantly, what is the P&L effect due to liquidity of different assets?

In earlier chapters, when we examined the P&L distribution, we ignored any effect of bid-offer spread, the impact on market prices of buying or selling our holdings, or over what period we might execute a transaction. We assumed that all transactions were done instantaneously and at midmarket. This was fine because our main focus was market movements and we could afford to ignore transactions costs. Here we change gears and focus primarily on those transactions costs.²

Costs and Benefits of Speedy Liquidation

Liquidity and transactions costs generally affect the P&L through two mechanisms. First is the bid-offer spread. Virtually any asset will have a price at which we can buy (the market offer) and a lower price at which we can sell (the market bid). When we liquidate, we go from the midmarket (at which we usually mark the positions) to the worse of the bid or offer. Illiquid assets will be characterized by a wide spread. Furthermore, spreads may vary by the size of the transaction and the state of the market. A transaction that is large relative to the normal size or that is executed during a period of market disruption may be subject to a wider bid-offer spread.

The second mechanism through which liquidity and transactions costs enter is the fact that market prices ...