LO 5.2: Describe exogenous and endogenous liquidity risk and explain how they

LO 5.2: Describe exogenous and endogenous liquidity risk and explain how they m ight be integrated into VaR models.
During times of a financial crisis, market liquidity conditions change, which changes the liquidity horizon of an investment (i.e., the time to unwind a position without materially affecting its price). Two types of liquidity risk are exogenous liquidity and endogenous liquidity. Both types of liquidity are important to measure; however, academic studies suggest that risk valuation models should first account for the impact of endogenous liquidity.
Professors Note: In Book 3, we w ill examine the estimation o f liquidity risk using the exogenous spread approach and the endogenous price approach.
Exogenous liquidity is handled through the calculation of a liquidity-adjusted VaR (LVaR) measure, and represents market-specific, average transaction costs. The LVaR measure incorporates a bid/ask spread by adding liquidity costs to the initial estimate of VaR.
Endogenous liquidity is an adjustment for the price effect of liquidating positions. It depends on trade sizes and is applicable when market orders are large enough to move prices. Endogenous liquidity is the elasticity of prices to trading volumes and is more easily observed in instances of high liquidity risk.
Poor market conditions can cause a flight to quality, which decreases a traders ability to unwind positions in thinly traded assets. Thus, endogenous liquidity risk is most applicable to exotic/complex trading positions and very relevant in high-stress market conditions, however, endogenous liquidity costs will be present in all market conditions.
R i s k M e a s u r e s

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