Liquidity Risk Essay

5758 words - 24 pages

Reserve Bank of India Occasional Papers Vol. 25, No. 1, 2 and 3, Summer, Monsoon and Winter 2004

Liquidity Adjustment in Value at Risk (VaR) Model: Evidence from the Indian Debt Market
Sunando Roy*
Conventional Value at Risk models are severely constrained while dealing with liquidity risk. This inevitably leads to an underestimation of overall risk and consequently misapplication of capital for the safety of financial institutions. Standard Value at Risk (VaR) model assumes that any quantity of securities can be traded without influencing market prices. In reality, most markets are less than perfectly liquid and many securities cannot be traded with ease in markets. This is especially ...view middle of the document...

Keywords : Liquidity Risk, Volatility, Value at Risk, GARCH, Turnover, Liquidity Adjustment Facility.

Introduction Liquidity in financial market implies the ability to transact large amount of securities quickly at low cost. Classically allied to the notions of marketability and market depth, the accepted definition of liquidity is in terms of the deviation of the market price from fair value due to trading frictions. This is quantified by, among others,
* Assistant Adviser, Department of Economic Analysis and Policy, Reserve Bank of India. The paper was presented at the Seventh Money and Finance Conference at Indira Gandhi Development Research Institute (IGIDR) in February 2005. I thank Philippe Jorion, Rene Stulz, Dilip Nachane, Vikas Chitre and A. V. Rajwade for their comments on the paper. The views in this paper are those of the author and not necessarily of the institution to which he belongs.

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RESERVE BANK OF INDIA OCCASIONAL PAPERS

the bid-ask spreads, turnover information and processing costs. According to Black (1971), a market is liquid if, at any time, (a) there is an ‘ask price’ and a ‘bid price’ for an investor who wants to buy or to sell immediately a minimal quantity imposed by the market authorities; (b) the bid-ask spread is always tight; (c) in the absence of a ‘special’ information, an investor who wants to buy or to sell a big quantity can expect a price, on average, close to the current market price; (d) an investor can buy or sell a large ‘block’ immediately by paying a premium (discount) which is positively related to the volume. BIS (1999) defines asset liquidity according to at least one of three dimensions: depth, tightness and resilience. Tightness, measured by bid-ask spread, indicates how far transaction price diverges from the mid-price. Depth defines the maximum number of shares that can be traded without affecting prevailing quoted market prices. Finally, resilience denotes the speed with which price fluctuations resulting from trades are dissipated or how quickly markets clear order imbalances. Despite episodic evidences of liquidity crisis in Indian financial markets, risks associated with market illiquidity have not been effectively incorporated into the Value-at-Risk (VaR) models. In the face of sudden and persisting off-market prices of some of the securities in their portfolio, the Indian financial organizations often found it difficult to offload these securities without booking significant trading losses. Moreover, in most cases, risk measures failed to capture the costs of carrying illiquid assets in their portfolio. As a consequence, a whole bunch of securities were not traded by financial firms. This became a constraining factor for market growth. With the gradual move towards marking to market of the portfolio to truly capture the risks of holding the securities, the pricing of untraded illiquid assets posed an additional challenge. For many securities, actual trades were absent on many...

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