LO 52.3: Describe the challenges of estimating liquidity-adjusted VaR (LVaR).

LO 52.3: Describe the challenges of estimating liquidity-adjusted VaR (LVaR).
One of the challenges of estimating liquidity-adjusted value at risk (LVaR) is choosing the best method. As in most choices, there is a tradeoff between sophistication and ease of implementation, and it is worth noting that sophistication and usefulness are not necessarily positively correlated. It is recommended to find approaches that are transparent in their assumptions and simple to implement (e.g., implementable with just a spreadsheet). A good way to do this is to determine liquidity add-ons that allow a researcher to modify original VaR estimates that did not include factors for illiquidity. In addition to addressing liquidity, the approach can also assess the impact of assumptions on estimates of VaR.
.Another challenge is liquidity adjustments that are compatible with the basic VaR approach and each other. This is because different methods look at different aspects of illiquidity, and it can be helpful to combine add-ons that give the best overall liquidity adjustment. In other words, two less sophisticated methods may be much better than one really good sophisticated method.
Another challenge is to check how the liquidity adjustment changes other inputs, such as the confidence level, holding period, or any other parameters (i.e., the sensitivity of the other inputs to the liquidity adjustment). The researcher should be aware of some basic relationships (e.g., an increase in the holding period should lower the level of the liquidity adjustment).
The researcher should try to calibrate the model against real data (e.g., check if the bid-ask spread parameters are empirically plausible), and properly stress test the model, as well as backtest the model. The researcher should be aware that there is probably not a single, best
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Topic 52 Cross Reference to GARP Assigned Reading – Dowd, Chapter 14
approach that would exclude the use of all others. Furthermore, using different approaches can help highlight different liquidity concerns.