What do we know about Liquidity Risk?

Liquidity is often described as the new frontier in academic research on financial markets. From a practitioner perspective, financial crises such as the 1997 Asian crisis and the 2007/2008 global financial crisis, have reminded market participants of the importance of taking into account liquidity as a factor when evaluating investment opportunities and when designing risk management systems. But how much do we really know about Liquidity Risk? How do we measure it? How do we manage it?

Liquidity Risk comes in two species – funding risk and market liquidity risk. Each operates at a different level of analysis, the first is liquidity risk at the level of the institution, how do we ensure that an organization (like a bank) can survive the variable inflows and outflows of cash over a particular time period. Such Funding Risk is really an outgrowth of ALM, and seeks to design the balance sheet to be robust when facing sudden outflows of cash. Techniques like cash flow gaps, cash flow forecasting, use of liquidity reserves, contingency planning, crisis management, etc. are all key components of funding risk.

Market liquidity risk is at the level of individual assets, and measures our inability to convert assets into cash in a reasonable timeframe. There are many ways to model market liquidity. Some extend the traditional VaR approach into an Liquidity VaR model based on the bid ask spread, using either an empirical or a theoretical distribution to derive an add-on to the VaR that incorporates the potential change in spread. Others use regression models trying to relate historical price changes to volume changes (after adjusting for all the usual Fama – French beta factors). A third approach looks at limit order books and tries to infer the embedded liquidity in those reserve prices for off market orders. A final stream of research looks at the optimal trading strategies associate with illiquid assets – in the presence of illiquidity and other transaction costs how do bring down my position in illiquid assets within a certain time period.

Although strictly speaking, not liquidity risk per se, another stream of research is hard at work extending trading pricing models (e.g., CAPM) to incorporate systematic illiquidity as a source of asset returns and typically argues that what is often viewed as a source of alpha, is really poorly measured and understood beta in the form of an illiquidity premium.