What is Liquidity risk?

Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.

Liquidity risk has different meanings in different contexts. In investing terms, bondholders face varying liquidity risks based on the likelihood that they may have to sell a bond below its listed value. This type of liquidity risk can actually extend to any security, describing the risk that an asset finds no buyers due to lack of liquidity in its given market. In economics and business management, liquidity refers to the ability of a financial institution to meet its operational and debt obligations without incurring severe losses or defaulting.

Liquidity risk is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. With liquidity risk, typically reflected in unusually wide bid-ask spreads or large price movements, the rule of thumb is that the smaller the size of the security or its issuer, the larger the liquidity risk. Drops in the value of stocks and other securities in the aftermath of the 9/11 attacks and the 2007-2008 global credit crisis motivated many investors to sell their holdings at any price, causing widening bid-ask spreads and large price declines, which further contributed to market illiquidity.

Liquidity risk occurs when an individual investor, business or financial institution cannot meet short-term debt obligations. The investor or entity may be unable to convert an asset into cash without giving up capital and/or income due to a lack of buyers or an inefficient market. For example, a $500,000 home may have no buyer when the real estate market is down. When the market goes up, the home may sell above its list price. However, if the owner needs cash quickly when the market is down, he may sell the home for less and lose money on the transaction. Due to liquidity risk, investors should consider whether they can cover their short-term debt obligations into cash before investing in long-term illiquid assets.

Liquidity risk is the probability of loss arising from a situation where

1. there will not be enough cash and/or cash equivalents to meet the needs of depositors and borrowers,
2. sale of illiquid assets will yield less than their fair value, or
3. illiquid assets will not be sold at the desired time due to lack of buyers.

Some assets may be hard to sell if:

1. there is an inefficient secondary market,
2. the asset is not highly sought after, or
3. the economy is sluggish and therefore potential buyers are cautious.

Types of liquidity risk

Liquidity risk is divided into two types: market liquidity risk (aka asset/product risk) and funding liquidity risk (aka cash-flow risk).

Market liquidity – An asset cannot be sold due to lack of liquidity in the market – essentially a sub-set of market risk. This can be accounted for by:

• Widening bid/offer spread;
• Making explicit liquidity reserves;
• Lengthening holding period for VaR calculations.

Funding liquidity – Risk that liabilities:

• Cannot be met when they fall due;
• Can only be met at an uneconomic price;
• Can be name-specific or systemic.

Causes of liquidity risk

Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade for that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade.

Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset’s price to zero, the market is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other. This is why liquidity risk is usually found to be higher in emerging markets or low-volume markets.

Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity.

Market and funding liquidity risks compound each other as it is difficult to sell when other investors face funding problems and it is difficult to get funding when the collateral is hard to sell. Liquidity risk also tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk.

A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk example – the two payments are offsetting, so they entail credit risk but not market risk. Another example is the 1993 Metallgesellschaft debacle. Futures contracts were used to hedge an Over-the-counter finance OTC obligation. It is debatable whether the hedge was effective from a market risk standpoint, but it was the liquidity crisis caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions.

Accordingly, liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults.

Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organization’s cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general approach using scenario analysis might entail the following high-level steps:

• Construct multiple scenarios for market movements and defaults over a given period of time.
• Assess day-to-day cash flows under each scenario.

Because balance sheets differ so significantly from one organization to the next, there is little standardization in how such analyses are implemented.

Regulators are primarily concerned about systemic implications of liquidity risk.

Pricing of liquidity risk

Risk-averse investors naturally require higher expected return as compensation for liquidity risk. The liquidity-adjusted CAPM pricing model therefore states that, the higher an asset’s market-liquidity risk, the higher its required return.

A common method for estimating the upper bound for a security illiquidity discount is by using a Lookback option, where the premia is equal to the difference between the maximum value of a security during a restricted trading period and its value at the end of the period. When the method is extended for corporate debt it is shown that liquidity risk increases with a bond credit risk.

An illiquid security has a higher required return to compensate investors for the transaction costs. Since market liquidity may deteriorate when you need to sell in the future, investors face market liquidity risk. Investors naturally want to be compensated for this, so market liquidity risk increases the required return. Indeed, the liquidity-adjusted capital asset pricing model shows how liquidity betas complement the standard market beta. The higher required return in times of higher market liquidity risk leads to a contemporaneous drop in prices, according to this theory, consistent with what we are seeing in the current marketplace.

Measures of liquidity risk

Liquidity gap

Culp defines the liquidity gap as the net liquid assets of a firm. The excess value of the firm’s liquid assets over its volatile liabilities. A company with a negative liquidity gap should focus on their cash balances and possible unexpected changes in their values.

As a static measure of liquidity risk it gives no indication of how the gap would change with an increase in the firm’s marginal funding cost.

Liquidity risk elasticity

Culp denotes the change of net of assets over funded liabilities that occurs when the liquidity premium on the bank’s marginal funding cost rises by a small amount as the liquidity risk elasticity. For banks this would be measured as a spread over libor, for nonfinancials the LRE would be measured as a spread over commercial paper rates.

Problems with the use of liquidity risk elasticity are that it assumes parallel changes in funding spread across all maturities and that it is only accurate for small changes in funding spreads.

Measures of asset liquidity

Bid-offer spread

The bid-offer spread is used by market participants as an asset liquidity measure. To compare different products the ratio of the spread to the product’s bid price can be used. The smaller the ratio the more liquid the asset is.

This spread is composed of operational, administrative, and processing costs as well as the compensation required for the possibility of trading with a more informed trader.

Market depth

Hachmeister refers to market depth as the amount of an asset that can be bought and sold at various bid-ask spreads. Slippage is related to the concept of market depth. Knight and Satchell mention a flow trader needs to consider the effect of executing a large order on the market and to adjust the bid-ask spread accordingly. They calculate the liquidity cost as the difference of the execution price and the initial execution price.

Immediacy

Immediacy refers to the time needed to successfully trade a certain amount of an asset at a prescribed cost.

Resilience

Hachmeister identifies the fourth dimension of liquidity as the speed with which prices return to former levels after a large transaction. Unlike the other measures resilience can only be determined over a period of time.

Managing liquidity risk

Liquidity-adjusted value at risk

Liquidity-adjusted VAR incorporates exogenous liquidity risk into Value at Risk. It can be defined at VAR + ELC (Exogenous Liquidity Cost). The ELC is the worst expected half-spread at a particular confidence level.

Another adjustment, introduced in the 1970s with a regulatory precursor to today’s VAR measures, is to consider VAR over the period of time needed to liquidate the portfolio. VAR can be calculated over this time period. The BIS mentions “… a number of institutions are exploring the use of liquidity adjusted-VAR, in which the holding periods in the risk assessment are adjusted by the length of time required to unwind positions”.

Liquidity at risk

Alan Greenspan (1999) discusses management of foreign exchange reserves and suggested a measure called Liquidity at risk. A country’s liquidity position under a range of possible outcomes for relevant financial variables (exchange rates, commodity prices, credit spreads, etc.) is considered. It might be possible to express a standard in terms of the probabilities of different outcomes. For example, an acceptable debt structure could have an average maturity—averaged over estimated distributions for relevant financial variables—in excess of a certain limit. In addition, countries could be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowing for one year with a certain ex ante probability, such as 95 percent of the time.

Scenario analysis-based contingency plans

The FDIC discuss liquidity risk management and write “Contingency funding plans should incorporate events that could rapidly affect an institution’s liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty.” Greenspan’s liquidity at risk concept is an example of scenario based liquidity risk management.

Diversification of liquidity providers

If several liquidity providers are on call then if any of those providers increases its costs of supplying liquidity, the impact of this is reduced. The American Academy of Actuaries wrote “While a company is in good financial shape, it may wish to establish durable, ever-green (i.e., always available) liquidity lines of credit. The credit issuer should have an appropriately high credit rating to increase the chances that the resources will be there when needed.”

Derivatives

Bhaduri, Meissner and Youn discuss five derivatives created specifically for hedging liquidity risk:

• Withdrawal option: A put of the illiquid underlying at the market price.
• Bermudan-style return put option: Right to put the option at a specified strike.
• Return swap: Swap the underlying’s return for LIBOR paid periodicially.
• Return swaption: Option to enter into the return swap.
• Liquidity option: “Knock-in” barrier option, where the barrier is a liquidity metric.