1. Liquidity Risk
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 1

2. Types of Liquidity Risk
Liquidity trading risk
Liquidity funding risk
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 2

3. Liquidity Trading Risk
Price received for an asset depends on
The mid market price
How much is to be sold
How quickly it is to be sold
The economic environment
As we found in August 2007 transparency is factor that affects liquidity
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 3

4. Bid-Offer Spread As a Function of Quantity
Offer Price
Bid Price
Quantity
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 4

5. Bid-Offer Spread
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 5

6. Example 1
Suppose that a financial institution has bought 10 million shares of one company and 50 million ounces of a commodity.The shares are bid $89.5,offer$90.5. The commodity is bid $15, offer $15.1. The cost of liquidation in a normal market is ?
The mid-market value of the position in the share is
90×10=900 million;
in the commodity is ×50=752.50million
the bid-offer spread for share is 1/90=
for commodity is /15.05=
cost of liquidation
900× ×1/ × ×1/2=7.5million

7. Cost of Liquidation in Stressed Markets
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 7

8. Example 2
Suppose that in Example 1 the mean and standard deviation for the proportional bid-offer spread for the shares are and ; for the commodity are both Assuming that the spreads are normally distributed, the cost of liquidation that we are 99% confident,thatλ=2.33
900×1/2( × )+752.5×( × )=73.25

9. Liquidity-Adjusted VaR
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 9

10. Unwinding a Position Optimally
Suppose dollar bid-offer spread as a function of units traded is p(q)
Suppose standard deviation of mid-market price changes per day is s
Suppose that qi is amount traded on day i and xi is amount held on day i (xi = xi-1−qi)
Trader’s objective might be to choose the qi to minimize
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 10

11. Example 19.3
A trader wishes to unwind a position in 100 million units over 5 days
p(q) = a+becq with a = 0.1, b = 0.05, and c = 0.03
The standard deviation of price change per day is 0.1
With 95% confidence level the amounts that should be traded on successive days is 48.9, 30.0, 14.1, 5.1, and 1.9
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 11

12. Liquidity Funding Risk
Sources of liquidity
Liquid assets
Ability to liquidate trading positions
Wholesale and retail deposits
Lines of credit and the ability to borrow at short notice
Securitization
Central bank borrowing
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 12

13. Examples of Liquidity Funding Problems
Northern Rock
Ashanti Goldfields
Metallgesellschaft
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 13

14. Liquidity Black Holes
A liquidity black hole occurs when most market participants want to take one side of the market and liquidity dries up
Examples:
Crash of 1987
British Insurance Companies
LTCM
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 14

15. Positive and Negative Feedback Trading
A positive feedback trader buys after a price increase and sells after a price decrease
A negative feedback trader buys after a price decrease and sells after a price increase
Positive feedback trading can create or accentuate a black hole
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 15

16. Reasons for Positive Feedback Trading
Computer models incorporating stop-loss trading
Dynamic hedging a short option position
Creating a long option position synthetically
Margin calls
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 16

17. The Impact of Regulation
If all financial institution were regulated in the same way, they would tend to react in the same way to market movements
This has the potential to create a liquidity black hole
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 17

18. The Leveraging Cycle
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 18

19. The Deleveraging Cycle
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 19

20. Is Liquidity Improving?
Spreads are narrowing
But arguably the risks of liquidity black holes are now greater than they used to be
We need more diversity in financial markets where different groups of investors are acting independently of each other
Risk Management and Financial Institutions 2e, Chapter 19, Copyright © John C. Hull 2009 20