LO 54.7: Explain methods to measure and manage funding liquidity risk and transactions liquidity risk.
An asset is liquid if it resembles money. That is, it can be exchanged for goods or services quickly and at a certain value. However, assets have to be liquidated in order to buy goods and services because we do not have a barter economy.
Transactions liquidity implies that an asset can be bought or sold without moving its price. However, large transactions may move an assets price because they create a short-term imbalance between supply and demand. Transactions liquidity risk is fundamentally related to the costs of searching for a counterparty, the institutions required to assist in that search, and the costs of inducing a counterparty to hold a position.
In order to understand transactions liquidity risk, it is important to understand market microstructure fundamentals. These fundamentals are: Trade processing costs. The first cost is associated with finding a counterparty in a timely fashion. In addition, processing costs, clearing costs, and the costs of settling trades must also be considered. These costs do not typically increase liquidity risk except in circumstances, either natural or man-made, where the trading infrastructure is affected. Inventory management. Dealers provide trade immediacy to market participants. The dealer must hold long or short inventories of assets and must be compensated by price concessions. This risk is a volatility exposure.
Adverse selection. There are informed and uninformed traders. Dealers must
differentiate between liquidity or noise traders and information traders. Information traders know if the price is wrong. Dealers do not know which of the two are attempting to trade and thus must be compensated for this lemons risk through the bid-ask spread. The spread is wider if the dealer believes he is trading with someone who knows more than he does. However, the dealer does have more information about the flow of trading activity (i.e., is there a surge in either buy or sell orders).
Differences of opinion. It is more difficult to find a counterparty when market
participants agree (e.g., the recent financial crisis where counterparties were afraid to trade with banks because everyone agreed there were serious problems) than when they disagree. Investors generally disagree about the correct or true price on an asset and about how to interpret new information about specific assets.
These fundamentals differ across different types of market organizations. For example, in a quote-driven system, common in over-the-counter (OTC) markets, market makers are expected to publicly post 2-way prices or quotes and to buy or sell at those prices within identified transaction size limits. In contrast, order-driven systems, typically found on organized exchanges, are more similar to competitive auction models. Typically the best bids and offers are matched throughout the trading session.
Liquidity risks are introduced when bid-ask spreads fluctuate, when the traders own actions impact the equilibrium price of the asset (called adverse price impact) and when the price of an asset deteriorates in the time it takes a trade to get done (called slippage).
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Topic 54 Cross Reference to GARP Assigned Reading – Malz, Chapter 12
In general, regulators have focused more on credit and market risks and less on liquidity risk. Liquidity risk is difficult to measure. However, since the financial crisis, more attention is being paid to measuring liquidity risks in a firm.
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