Liquidity Risk

Date: May 24, 2010

Back in mid 2007, when the credit crisis first started to unleash its trail of wreckage, everyone was using risk models that focused on market risks. All these models assumed Liquidity was always available, but when everyone’s risk model says “sell”, who is going to buy and if no one will buy then there is only one direction the market will go. In many ways the so called Credit Crunch was really a liquidity freeze. It is certainly true that there were many assets of dubious quality being sold as though they were high quality and once this became apparent investors didn’t stop to analyse carefully which assets were good and which were bad they fled for the exit. At this point they tested the capacity of the market to function – who will buy an asset no one wants? Of course shrewder investors with deep pockets were able to pick up bargains and after a while the market recovered its poise.

To help our clients StatPro has just launched its new measure of liquidity risk which can be used in conjunction with our Value at Risk (VaR) analysis and another innovation of StatPro; Hybrid VaR. In producing our liquidity risk measure we seek to measure the likely percentage discount that an investor would have to accept if he wanted to sell the asset immediately. The measure also works out portfolio liquidity risk. This is very useful for a manager to have to set against their daily NAV. After all the NAV is the sum of the market valuations for the assets in the portfolio but does not represent necessarily how much you cash you would get if you liquidated the entire portfolio. That would be somewhere between the NAV and the NAV minus the Liquidity risk. Of course Liquidity risk will vary from day to day and in different scenarios so we also provide our clients with liquidity risk scenarios. A typical fund might have a daily liquidity risk of less than 1% but in times of market panic that can rise to 15% or more.

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This analysis can be very useful to add colour to portfolio analysis. A number of assets in a portfolio might have the same level of VaR, but a completely different level of liquidity and it is precisely in times of stress that you don’t want to have to make forced sales. This was a common situation in 2009 when fund managers had to sell good assets at silly prices to meet cash calls because they could not sell other assets at any price.

Northern Rock famously got itself in trouble because it was financing long term assets (mortgages) with short term liabilities and when they could not refinance their liquidity crisis scuppered them. Mutual Fund managers that buy clever but illiquid derivatives that enhance their performance face a cash squeeze if their small investors want their money back. Matching funding liquidity to investment liquidity is important and having a sensible measure for it that can show a manager his potential weaknesses at a glance is essential.

Please let me know your thoughts in the comments section below.

If you want to know more about our new Liquidity Risk measure download our latest whitepaper on Market Liquidity Risk or read more about our Liquidity Risk Approach.

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