Liquidity risk
1134291
224120520
2008-07-07T12:05:26Z
Treasuryexpert
7435144
Risk definition
''''Liquidity risk – a definition'''
The risk that a bank or corporation, although balance sheet solvent, cannot meet or generate sufficient cash resources to meet its payment obligations in full as they fall due, or can only do so at materially disadvantageous terms.
<br />'''Asset liquidity''' an asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of market risk. Can be accounted for by:
(1) Widening bid/offer spread
(2) Making explicit liquidity reserves
(3) Lengthening holding period for VaR calculations
<br />'''Funding liquidity''' Risk that liabilities:
(1) Cannot be met when they fall due
(2) Can only be met at an uneconomic price
(3) Can be name-specific or systemic
<br />'''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 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 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.
Liquidity risk 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 contract|Futures]] 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|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 security|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 sheet]]s 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. <ref>http://www.bis.org/publ/bcbs138.pdf Principles for Sound Liquidity Risk Management and Supervision</ref>
==See also==
*[[Credit risk]]
*[[Currency risk]]
*[[Legal risk]]
*[[Market risk]]
*[[Optimism bias]]
==References==
{{reflist}}
* {{cite book | author=Crockford, Neil | title=An Introduction to Risk Management (2nd ed.) | publisher=Woodhead-Faulkner | year=1986 | id=0-85941-332-2}}
* {{cite book | author=van Deventer, Donald R., Kenji Imai and Mark Mesler| title=Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management | publisher=John Wiley| year=2004 | id= ISBN-13: 978-0470821268}}
[[Category:Risk in finance]]
[[id:Risiko likuiditas]]