Liquidity Risk

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Liquidity Risk</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#Liquidity risk">liquidity risk</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p><b><a name="Liquidity risk">Liquidity risk</a></b> is financial <a href="../articles/risk.htm">risk</a> due to uncertain <a href="../articles/liquidity.htm">liquidity</a>. An institution might lose liquidity if its <a href="../articles/credit_risk.htm">credit rating</a> 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.</p> <p>Liquidity risk tends to compound other risks. If a trading organization has a position in an <a href="../articles/liquidity.htm">illiquid</a> asset, its limited ability to liquidate that position at short notice will compound its <a href="../articles/market_risk.htm">market risk</a>. 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 we default. Here, liquidity risk is compounding <a href="../articles/credit_risk.htm">credit risk</a>.</p> <p>Obviously, a position can be <a href="../articles/hedging_and_diversification.htm">hedged</a> 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 <a href="../articles/risk_management.htm">Metallgesellschaft Debacle</a>. <a href="../articles/future.htm">Futures</a> were used to hedge an <a href="../articles/exchange_traded.htm">OTC</a> obligation. It is debatable whether the hedge was effective from a market risk standpoint, but it was the liquidity crisis caused by staggering <a href="../articles/collateral.htm">margin calls</a> on the futures that forced Metallgesellschaft to unwind the positions.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table6"> <tr> <td width="336" height="10"><font size="2"> </font></td> <td width="9" height="10"></td> </tr> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p>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 <a href="../articles/risk_metric_and_risk_measure.htm">metrics</a> of liquidity risk don't exist. Certain techniques of <a href="../articles/asset_liability_management.htm">asset-liability management</a> 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 <a href="../articles/stress_testing.htm">stress testing</a>. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults. </p> <p>Obviously, such analyses cannot take into account contingent cash flows, such as cash flows from <a href="../articles/derivative_instrument.htm">derivatives</a> or <a href="../articles/mortgage_backed_security.htm">mortgage-backed securities</a>. If an organization's cash flows are largely contingent, liquidity risk may be assessed using some form of <a href="../articles/scenario_analysis.htm">scenario analysis</a>. 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 differed so significantly from one organization to the next, there is little standardization in how such analyses are implemented. </p> <p>Regulators are primarily concerned about <a href="../articles_old/glossarysystemicrisk.htm">systemic</a> implications of liquidity risk. </p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table7"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table8"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/asset_liability_management.htm">asset-liability management</a> <strong style="font-weight: 400">Techniques for protecting a firm's solvency in the context of accrual accounting.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/credit_risk.htm">credit risk</a> Risk due to uncertainty in a counterparty's ability to perform on an obligation.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/risk_management.htm">financial risk management</a> Practices by which a firm optimizes the manner in which it takes financial risk.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/gap_analysis.htm">gap analysis</a> A technique of asset-liability management used to assess interest rate risk or liquidity risk.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/legal_risk.htm">legal risk</a> Risk from uncertainty due to legal actions or uncertainty in the applicability or interpretation of contracts, laws or regulations.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/leverage.htm">leverage</a> Debt financing or anything that can similarly magnify the risk and reward of an investment.</p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/liquidity.htm">liquidity</a> Term used in various senses, all relating to availability of, access to, or convertibility into cash.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/market_risk.htm">market risk</a> Risk due to uncertainty in the market value of a portfolio.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/operational_risk.htm">operational risk</a> Sometimes defined as encompassing all financial risks other than market and credit risks.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/risk.htm">risk</a> Comprises two components: uncertainty and exposure.</p> </td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_1.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%">  <p class="ad_legend" style="margin-left: 0; margin-bottom:2"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font color="#000000">Ads by Contingency Analysis</font></a></p> <p style="margin-top: 0; margin-bottom: 0"> <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=iframe" style="margin: 0px; padding: 0px; border-width: 0px" width="336" height="265" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" name="I1"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=336x265;setID=82436"> <img src="http://servedbyadbutler.com/adserve.ibs/;ID=147917;size=336x265;setID=82436;type=img" border="0" height="265" width="336" alt=""></a> </noscript><![endif]></iframe>   </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table9"> <tr> <td width="100%"> <p class="explanatory_text">Persaud (<a target="_blank" href="http://www.riskbook.com/link/persaud_avinash_(2003).htm">2003</a>) is an edited collection looking at different aspects of liquidity risk. Harris (<a target="_blank" href="http://www.riskbook.com/link/harris_larry_(2003).htm">2003</a>) is an outstanding text on all aspects of trading. It discusses liquidity risk in depth. Schwartz and Francioni (<a target="_blank" href="http://www.riskbook.com/link/schwartz_and_francioni_(2004).htm">2004</a>) is the essential text on liquidity risk in equity markets. Das (<a target="_blank" href="http://www.riskbook.com/link/das_satyajit_(2003).htm">2003</a>) discusses liquidity risk in OTC derivatives markets.</p> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table10"> <tr> <td width="100" align="left" valign="top"> <img border="0" src="../images/book_persaud_avinash_(2003)_125.gif" usemap="#FPMap369" width="85" height="125"><map name="FPMap369"></map></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table11"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/persaud_avinash_(2003).htm">Liquidity Black Holes</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Avinash D. 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