LO 52.6: Describe liquidity at risk (LaR) and compare it to LVaR and VaR,

LO 52.6: Describe liquidity at risk (LaR) and compare it to LVaR and VaR, describe the factors that affect future cash flows, and explain challenges in estimating and modeling LaR.
Liquidity at risk (LaR) is also known as cash flow at risk (CFaR) and is the maximum likely cash outflow over the horizon period at a specified confidence level. A positive (negative) value for LaR means the worst outcome will be associated with an outflow (inflow) of cash. LaR is similar in concept to VaR, but instead of a change in value, it deals with a cash flow. LaR is also distinct from liquidity-related losses, but they are related.
As an example, an investor has a large market risk position that is hedged with a futures position. If the hedge is a good one, the basis risk is small, and the VaR should be small. There is the possibility of margin calls on the futures position, however, and this means there is the possibility of a cash outflow equal to the size of that position. In summary, the hedged position has a small VaR but a large LaR. At the other extreme, European options have zero LaR until expiration, but potentially large VaR prior to maturity.
The following is a list of factors that influence cash flows and LaR: Borrowing or lending. Margin requirements on market risk positions that are subject to daily marking to market. Collateral obligations, such as those on swaps, which can generate inflows or outflows of
cash from changes in market factors, such as interest rates.
Jarrow, R.A. and A. Subramanian. (1997). Mopping up liquidity. Risk 10 (December): 170-173.
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Topic 52 Cross Reference to GARP Assigned Reading – Dowd, Chapter 14
Short explicit options or implicit options (e.g., convertibility and call features).
Changes in risk management policy (e.g., a change in the type of hedge), which may
change mark-to-market requirements.
Two other considerations are as follows: (1) LaR can increase when the firm is facing hard times (e.g., a credit downgrade increases the rate on bank loans); and (2) there are positions that are similar in terms of market risk (e.g., a futures versus an options hedge), but are very different in terms of LaR.
As a practical matter for the firm attempting to estimate LaR, consider using the firms VaR procedures to estimate the VaRs of marginable securities and then combine this LaR estimate with comparable figures from other sources of liquidity risk within the organization to produce an integrated measure of firm-wide liquidity risk. The point is to use the existing and accepted VaR procedures to estimate liquidity risks. It is obviously ad hoc, however, and a firm facing complex liquidity risks should build a more appropriate model. This would involve identifying and modeling the variables indicated in the following list: The certain cash flows (e.g., from U.S. Treasury investments). The unconditional uncertain cash flows (e.g., from risky bonds). The conditional uncertain cash flows (e.g., those that only result if a certain decision is
made, such as making an investment).
Other conditioning variables that might trigger cash flows. Having identified the factors, the manager can construct an appropriate engine to estimate the risks. Estimating the LaR may only require a variance-covariance approach, or it may require a more advanced simulation approach.
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