Ebook Liquidity Risk and Correlation Risk: Implications for Risk Management
There has been a surge in the recent academic literature on issues concerning liquidity (starting with Amihud and Mendelson, 1986) and liquidity risk (Pastor and Stambaugh, 2003, and Acharya and Pedersen, 2005). While practitioners would perhaps question the relatively late arrival of these topics into academic focus, academics have traditionally preferred to look at the world through the lens of complete, or at least frictionless markets. The limitations of this traditional approach have however become glaringly transparent over the last decade or two in the wake of major financial events in which the ability to trade securities and access capital-market financing declined substantially.
The most striking of these events include the stock market crash of 1987 in the United States, the Russian default in 1998, the Long Term Capital Management episode that followed, and, most recently, the aftermath of GM and Ford downgrade. It is thus timely and fitting to examine what we can learn from these events about sources of (il)liquidity and liquidity risk, and their implications for risk management at banks and financial institutions. As a part of this investigation, we will also look at the relation between the developing theory on liquidity risk and the apparently separate literature on correlation risk the fluctuations over time in the correlation of returns across securities.
A central difficulty with discussing issues relating to liquidity is the lack of consensus on what it means. Liquidity is clearly multi-faceted and perhaps also a somewhat loosely employed economic concept. To capital market participants, liquidity generally refers to transaction costs arising from bid-ask spreads, price impacts, and (limited) market depth for trading in securities. By token, liquidity risk for these participants generally refers to unpredictable variations in transaction costs.
We shall henceforth refer to this notion of liquidity and liquidity risk as pertaining to “market liquidity.” In contrast, and often times in addition, risk managers at banks and financial institutions are concerned about liquidity on the funding side, in other words, the ease with which cash shortfalls of the enterprise can be funded through various sources of internal or external financing. We shall refer to this as “funding liquidity” and its unpredictable fluctuations over time as funding liquidity risk.
In this paper, we start by observing that capital and collateral requirements for trading of securities introduce an important linkage between market liquidity and funding liquidity of financial intermediaries. This first step enables us to focus on causes, effects and implications of market liquidity shocks, with the additional consideration that these are also related to funding liquidity shocks: Lack of trading capacity reduces profits of intermediaries, brings them closer to capital or collateral constraints, and further restricts their ability to provide liquidity to markets.
Conversely, the collateral value of risky assets falls during periods of illiquidity and restricts the amount of secured funding that intermediaries can raise. While this linkage has been at the centre of some recent theoretical contributions (most notably, Gromb and Vayanos, 2002, and Brunnermeier and Pedersen, 2005), we focus on two important aspects that have hitherto received less direct attention in this literature.
Download
PDF Ebook Liquidity Risk and Correlation Risk: Implications for Risk Management
Posted in :
