Modeling Liquidity Risk

Financial Institutions Center

Modeling Liquidity Risk, With Implications for Traditional Market Risk Measurement and Management
by Anil Bangia Francis X. Diebold Til Schuermann John D. Stroughair 99-06

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Modeling Liquidity Risk With Implications for Traditional Market Risk Measurement and Management November 1998 This draft/print: December 21, 1998

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Abstract: Market risk management under normal conditions traditionally has focussed on thedistribution of portfolio value changes resulting from moves in the mid-price. Hence the market risk is really in a “pure” form: risk in an idealized market with no “friction” in obtaining the fair price. However, many markets possess an additional liquidity component that arises from a trader not realizing the mid-price when liquidating her position, but rather the mid-price minus the bid-askspread. We argue that liquidity risk associated with the uncertainty of the spread, particularly for thinly traded or emerging market securities under adverse market conditions, is an important part of overall risk and is therefore an important component to model. We develop a simple liquidity risk methodology that can be easily and seamlessly integrated into standard value-at-risk models, and weshow that ignoring the liquidity effect can produce underestimates of market risk in emerging markets by as much as 25-30%. Furthermore, we show that the BIS inadvertently is already monitoring liquidity risk, and that by not modeling it explicitly and therefore capitalizing against it, banks will be experiencing surprisingly many violations of capital requirements, particularly if their portfoliosare concentrated in emerging markets.

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Anil Bangia is at Oliver, Wyman & Company.

Francis X. Diebold is at the University of Pennsylvania, the Stern School, NYU, and the Oliver Wyman Institute. Til Schuermann is at Oliver, Wyman & Company. John D. Stroughair is at Oliver, Wyman & Company. We thank Steve Cecchetti and Edward Smith for helpful comments and suggestions. All remaining errorsare ours.

“Portfolios are usually marked to market at the middle of the bid-offer spread, and many hedge funds used models that incorporated this assumption. In late August, there was only one realistic value for the portfolio: the bid price. Amid such massive sell-offs, only the first seller obtains a reasonable price for its security; the rest loose a fortune by having to pay a liquiditypremium if they want a sale. …Models should be revised to include bid-offer behaviour.” Nicholas Dunbar (“Meriwether’s Meltdown,” Risk, October 1998, 32-36)

I. INTRODUCTION The recent turmoil in the capital markets has led experts and laymen alike to cast liquidity risk in the role of the culprit. Inexperienced and sophisticated players were all caught by surprise when markets dried up....