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. Unsurprisingly, the first to go were the emerging markets in Asia and more recently in Russia. Then it spilled over into the US corporate debt market which was indeed much more surprising. Its most famous victim has been Long Term Capital Management (LTCM). Spreads appeared to widen out of the blue; but this could have been predicted.

More generally, it is a well acknowledged fact that the standard Value-at-Risk (VaR) concept used for measuring both market and credit risk for tradable securities lacks a rigorous treatment of liquidity risk. At best, the risk for large illiquid positions is adjusted upwards in an ad hoc fashion by utilizing a longer time horizon in the calculation of VaR that at best is a subjective estimate of the likely liquidation time of the position. This holding-period adjustment is usually carried out using the square root of time scaling of the variances and covariances rather than a recalculation of variances and covariances for the longer time horizon.