LO 54.9: Explain interactions between different types of liquidity risk and explain

LO 54.9: Explain interactions between different types of liquidity risk and explain how liquidity risk events can increase systemic risk.
Liquidity is defined in many ways in financial markets. In general, an asset is liquid if it is close to cash. This means that the asset can be sold quickly, cheaply, and without moving the price too much. A market is liquid if positions can be unwound quickly, cheaply (i.e., at low transactions costs), and without undue price deterioration.
Liquidity has two essential properties, which relate to two essential forms of risk. Transactions liquidity deals with financial assets and financial markets. Funding liquidity is related to an individuals or firms creditworthiness. Risks associated with liquidity include: Transactions (or market) liquidity risk is the risk that the act of buying or selling an
asset will result in an adverse price move.
Funding liquidity risk or balance sheet risk results when a borrowers credit position is either deteriorating or is perceived by market participants to be deteriorating. It also occurs when the market as a whole deteriorates. Under these conditions, creditors may withdraw credit or change the terms of credit (e.g., increase the required collateral for the loan). The position may, as a result, be unprofitable or may need to be unwound. Balance sheet risks are higher when borrowers fund longer term assets with shorter term liabilities. This is called a maturity mismatch. Maturity mismatching is often profitable for firms because short-term investors bear less risk and have a lower required rate of return. This means that short-term debt financing contributes less to the overall cost of capital of a borrowing firm. The incentive to maturity mismatch is even greater when the yield curve is upward sloping. However, funding long-term assets with short-term
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Topic 54 Cross Reference to GARP Assigned Reading – Malz, Chapter 12

financing exposes the borrower to rollover risk (sometimes called cliff risk), the risk that the debt cannot be refinanced or can only be refinanced at escalating rates. Systemic risk is the risk that the overall financial system is impaired due to severe financial stress. With this risk, credit allocation is impaired across the financial system. Risks associated with liquidity are interrelated and can exacerbate problems. For example, if collateral requirements are increased, a counterparty may be forced to unwind a position early and at a potential loss. In this case, the increase in funding liquidity risk increases the transactions liquidity risk.
An important connection between funding and transactions liquidity is leverage. An investor with a long position may be forced to sell an asset if future funding for the asset dries up. This in turn would reduce the number of potential asset holders, leading to a reduction in asset valuation. It may be the case that this decline in price is temporary, however, the length of the depressed asset price could be long enough to adversely impact the solvency of the investor who initially purchased the asset. A rapid deleveraging of assets could lead to a debt-deflation crisis.
Transactions liquidity could also impair funding liquidity. For example, if a hedge fund is facing redemptions, it is forced to raise cash by selling assets and therefore must decide which assets to sell first. Selling highly liquid assets will lead to fewer adverse price impacts, but will leave the hedge fund with a more illiquid portfolio. On the other hand, selling highly illiquid assets will increase realized losses, which may put additional pressure on the portfolio from a funding liquidity standpoint.
The level of economy-wide liquidity directly impacts the level of systemic risk. When market conditions deteriorate, liquidity tends to become constrained just when investors need it the most. Liquidity risk events could potentially become systemic risk events through disruptions in payment, clearing, and settlement systems. Severe stress to the financial system would impact market participants simultaneously, suggesting that the illiquidity or insolvency of one counterparty may have a domino effect on other market participants throughout the system.
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