Liquidity risk

Summary

Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price. Types Market liquidity – An asset cannot be sold due to lack of liquidity in the market – essentially a sub-set of market risk. This can be accounted for by:

Widening bid–ask spread
Making explicit liquidity reserves
Lengthening holding period for value at risk (VaR) calculations Funding liquidity – Risk that liabilities:
Cannot be met when they fall due
Can only be met at an uneconomic price
Can be name-specific or systemic

Causes Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade for that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to t

Official source

About this result

This page is automatically generated and may contain information that is not correct, complete, up-to-date, or relevant to your search query. The same applies to every other page on this website. Please make sure to verify the information with EPFL's official sources.

Related publications

Related people

Related units

Related concepts

Related courses

Related lectures

The financial crisis of 2007-2009 drew attention to the essential role of banks for the macroeconomy and to the importance of having a resilient financial sector. A vulnerability in the financial sector spills over to the real economy and can drive it into a deep recession. Following the financial crisis, policy makers have issued rules and regulations aimed at strengthening the banks. My dissertation considers some of those measures, namely bank liquidity regulation and deposit insurance, and tries to assess their effectiveness in stabilizing the financial sector and the economy in general. The first chapter (joint with Prof. Luisa Lambertini) develops a model with regulated banks and a hedge fund to analyze the behavior of wholesale funding and the macroeconomic consequences of liquidity regulation. Banks raise deposits and subordinated wholesale funding from the hedge fund. Wholesale funding amplifies shocks: it is curtailed in economic downturns to avoid leveraging up and risk-taking by banks, further depressing credit and economic activity. By making banks safer, liquidity regulation increases wholesale funding and bank loans at the steady state. However, flat liquidity regulation requiring banks to hold a constant fraction of liquid assets can have unintended consequences and increase macroeconomic volatility. Our model further shows that cyclically adjusted regulation stabilizes the response of the economy to shocks. We also provide empirical evidence suggesting that liquidity helps contain the contraction in wholesale funding and loans during times of funding stress. The second chapter explores the macroeconomic and welfare implications of harmonizing or joining deposit insurance in the Eurozone. I develop a two-country model to represent the core and periphery countries in the Eurozone. The model features fragile banks that can be subject to endogenous and costly runs. The two countries are financially integrated through an international interbank market. I introduce deposit insurance and compare different insurance regimes in steady state and along the business cycle. The model emphasizes that financial integration implies co-movement in asset prices and the transmission of shocks across the border. I find that when deposit insurance has lower coverage in the periphery than in the core, financial stability is undermined in both regions due to higher asset price volatility and a higher probability of deposit runs. Hence, either harmonizing or joining deposit insurance leads to substantial welfare benefits for both countries. In the third chapter, I develop a macroeconomic model with multiple equilibria and bank runs to analyze deposit insurance. A bank run is a sunspot equilibrium, and it is caused by a self-fulfilling panic of all depositors. The model features a unique no-run equilibrium when macroeconomic conditions are good, but an unexpected negative shock may open up the possibility of a run equilibrium. A bank run is a rare but costly event that drives the economy in a long and severe recession. I analyze the introduction and build-up of a deposit insurance fund and show that it reduces the cost and probability of bank runs. The dynamic simulation of the model reveals that deposit insurance diminishes macroeconomic and financial instability following a technological shock.

EPFL2018

This thesis analyzes the interrelation between market structure and price formation in credit derivatives markets. Traditionally, credit derivatives are traded in relatively opaque over-the-counter markets in which trading is segmented and subject to many imperfections from which illiquidity may arise. Recent regulatory reforms have brought transparency to some credit derivatives markets without affecting their segmented structures. The first chapter, which is joint work with Anders B. Trolle, analyzes whether liquidity risk is priced in the cross section of returns on credit default swaps (CDSs). The analysis is based on a factor pricing model and a tradable liquidity factor that is constructed from returns on index arbitrage strategies. The underlying presumption is that violations of simple no-arbitrage relations between different CDS contracts reflect constraints on the risk-bearing capacity of CDS market intermediaries and, in broad terms, CDS market illiquidity. The analysis reveals priced liquidity risk in that credit protection sellers earn higher expected excess returns on CDS contracts with higher liquidity exposures. The liquidity risk premium is significant and accounts for 24% of CDS spreads, on average. CDS risk premia correlate negatively with proxies for the risk-bearing capacity of CDS market intermediaries, which is consistent with intermediary frictions affecting the pricing of CDSs. The second chapter, which is joint work with Pierre Collin-Dufresne and Anders B. Trolle, analyzes transaction costs in the dealer-to-customer (D2C) and dealer-to-dealer (D2D) segments of the post-Dodd-Frank index CDS market. Dodd-Frank regulations that made all-to-all trading possible had the potential to break up the market's segmented structure but failed to do so. This led to a controversy with some market participants arguing that the segmented structure is optimal and other market participants arguing that dealers maintain the segmented structure in order to limit competition by alternative liquidity providers. The analysis reveals that D2C trades indeed have larger transaction costs than D2D trades but that the differences in transaction costs reflect differences in price impacts rather than differences in profits from liquidity provision. D2C trades are even competitive relative to executable bids and offers in the D2D segment, suggesting that the market structure delivers favorable prices for customers who value immediacy. The third chapter documents a decline of transaction costs and profits from liquidity provision in the index CDS market over a two-and-a-half-year period during which Dodd-Frank regulations were implemented. Transaction costs and profits from liquidity provision declined around the introduction of so-called swap execution facilities (SEFs); i.e., regulated trading platforms that offer pre-trade transparent methods of trade execution. Trades that are executed on SEFs have lower transaction costs and are less profitable from a liquidity provider's perspective in comparison to bilaterally negotiated trades, which is consistent with better comparison shopping and stronger price competition on SEFs. Dodd-Frank regulations mandating on-SEF trade execution that were implemented after the introduction of SEFs did not affect transaction costs and profits from liquidity provision, suggesting that there is no incremental effect associated with mandatory pre-trade transparency.

EPFL2016

A daily return reversal measure of liquidity is developed and estimated using a new comprehensive ultra-high frequency data set of foreign exchange rates during the financial crisis period of 2007--2008. The measure captures market participants' perception of periods with high and low liquidity in the expected manner. Tests for commonality in foreign exchange (FX) liquidity show that liquidity co-moves strongly across currencies. Systematic FX liquidity decreases dramatically during the subprime crisis, especially after the default of Lehman Brothers in September 2008. To investigate whether there exists a return premium for illiquidity, a factor model similar to Lustig, Roussanov, and Verdelhan (2009) is augmented by a liquidity risk factor constructed from shocks to systematic liquidity. Empirical results indicate that liquidity risk is a heavily priced state variable important for the determination of FX returns. Previously identified risk factors such as the carry trade and market risk factors are no longer significant once common liquidity risk is incorporated in the asset pricing model. This finding helps to explain deviations from uncovered interest rate parity as classical tests do not include liquidity risk.

2009