Liquidity Risk

Liquidity risk may come up from circumstances where a counterparty who is eager to trade an asset is unable to perform it simply due to the reason that not a single party in the market is ready to buy or sell the asset.

Liquidity risk gets specifically significant to the parties who are interested to retain an asset at a particular point of time as that influences their merchandising ability. The expression of liquidity risk is quite distinctive from the decline of price to nil. In circumstances where the price of an asset has dropped down to nil, the market assumes that the asset has become valueless. Nevertheless, if one party is unable to find out another party who is ready to trade the asset, this might be a potential problem of the participants of the market for finding out one another. This is the reason behind liquidity risk being greater in small-volume markets or nascent markets.

Liquidity risk is also a form of financial risk because of inconsistent liquidity. The liquidity of a financial services provider may go down if the credit rating of that company declines or it suddenly witnesses unanticipated cash outflows or any other type of occurence that makes the parties to avert merchandising or loaning to the company. A business entity can also face the exposure to liquidity risk if the markets the firm is dependent on are prone to liquidity loss.

There is a tendency seen in liquidity risk of combining other types of risk. If a merchandizing institution holds a position for an asset, which is illiquid in nature, the restricted capacity for liquidating the position at a short time period would consolidate the market risks. If a business entity has compensatory cash flows from two separate counterparties on a particular day and the party, which is the borrower defaults on the payment, the institution has no other option but to collect money from other sources for making the payment. In case it is unable to do that, it will default again. In this case, liquidity risk combines credit risk.

Hedging of a position can be done from market risk, even though it will implicate liquidity risk. It is proven in the above mentioned example about credit risk, where there are two counterbalancing payments and as a result, they involve credit risk, however, no market risk is involved.

The management of liquidity risk is to be done additionally with credit risk, market risk and other types of risks. As liquidity risk has the tendency of consolidating other types of risks, it is hard or not possible to eliminate liquidity risk. Under the most fundamental situations, there is no presence of extensive measurements of liquidity risk. Specific methods of asset liability management may be implemented for the assessment of liquidity risk. A basic examination of liquidity risk is to observe net cash flows in the future on a daily basis. If on a particular day, there is a substantial amount of negative cash flow (net), it is a major concern.

This type of analysis may be appended by stress testing. Net cash flows on a daily basis are observed anticipating that a major counterparty will default.

These assessments do not take into consideration cash flows on contingency basis, for example cash flows from mortgage backed securities or derivatives. If the cash flows of a business entity are substantially contingent in nature, then the assessment of liquidity risk can be done utilizing some type of scenario analysis.

Commonly, the scenario analysis involves the following steps:

  • Formation of a large number of scenarios for market variations and defaults in a stipulated time period Analysis of cash flows in each scenario on a daily basis
  • As the balance sheets are different from one institution to another, there is minimum benchmarking about the implementations of these assessment methods.

The controllers of financial entities are principally worried about the general entailments of liquidity risk.

More Information Related to Finance Theory
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Binomial Options Pricing Model Capital Asset Pricing Model Cox Ingersoll Ross Model
Black Model Black Scholes Model Chen Model
Liquidity Risk Commodity Risk Consumer Credit Risk
Systemic Risk Currency Risk Market Risk
Interest Rate Risk Settlement Risk Equity Risk
Gordon Model Monte Carlo Option Model Ho Lee Model
Rendleman Bartter Model Vasicek Model Hull White Model
Rational Choice Theory Modern Portfolio Theory Cumulative Prospect Theory
Efficient Market Hypothesis Arrow Debreu Model International Fisher Effect
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Personal Budget Floating Exchange Rate Discount Rate

Last Updated on : 1st July 2013

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