Liquidity risk

In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).

Types of Liquidity Risk

Asset 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 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 finance 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 creit 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 and implications of liquidity risk.

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.

Financial risk

Financial risk is normally any risk associated with any form of financing. In this setting risk is synonymous with down risk or the probability of unfavorable condition; in financial sector it is the probability of actual return being less than expected return.

Investment related

Depending on the nature of the investment, the type of investment risk will vary. High risk investments have greater potential consequences, and typically provide greater potential rewards.

A common concern with any investment is that the initial amount invested may be lost (also known as "the capital"). This risk is therefore often referred to as capital risk.

If the invested assets are being held in another currency, there is a risk that currency movements alone may affect the value. This is referred to as currency risk.

Many forms of investment may not be liquid (e.g. commercial property) or the market has a small capacity and may therefore take time to sell. Therefore this type of risk is termed liquidity risk.

Business related

The risk that a company or project will not have adequate cash flow to meet financial obligations; thus causing the business to file for bankruptcy.

Financial risk is the additional risk a shareholder bears when a company uses debt in addition to equity financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly or entirely by equity.

Bilateral barter can depend upon a mutual coincidence of wants. Before any transaction can be undertaken, each party must be able to supply something the other party demands. To overcome this mutual coincidence problem, some communities had developed a system of intermediaries who can warehouse and trade goods. However, intermediaries often suffered from financial risk.

Whilst higher risk normally implies higher overall rewards, this is not always the case. For example a high risk mortgage client may be required to pay a higher interest rate on their mortgage repayments in order to be accepted as a bank's customer. However, this higher mortgage rate will in itself increase the risk to the bank that the customer cannot meet their interest payments, further increasing the risk.

This circular risk problem can lead to markets not existing for high risk borrowers. The 2007/8 sub-prime crisis may have some links to this argument. Higher interest rates for high risk borrowers make the borrowers even less likely to be able to pay back the loan, further increasing the default risk.

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