RISK MANAGEMENT

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Week8LectureNotesFinal.pdf

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FIN 562 Risk Management

Professor Mark Shore

DePaul University

Week 8 Lecture Notes

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Twitter @shorecap

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Liquidity Risk

2 Types of Liquidity Risk

• Liquidity Trading Risk ➢Relates to ability to enter and exit the market

• Liquidity Funding Risk ➢Relates to ability to pay obiligations

Liquidity Trading Risk

• More liquid = smaller bid – ask spread ➢Less slippage = lower cost to enter or exit the position

➢Less costly to enter and exit a market position

Liquidity Trading Risk • Factors for Price depends on:

• The mid market price

• Quantity = How much is to be sold

• Time = How quickly it is to be sold

• The economic environment

• Financial Crisis transparency is also a factor that affects liquidity: Mortgages: • More transparency = greater understanding of involved risk

• Unacceptable risks = reduced demand= less volume = wider bid- ask spreads = costlier to enter and exit the market

• 2007 investors were using credit ratings in place of understanding the risks

• When confidence declines; liquidity declines

• Sellers market

• Buyers market

• Predatory trading

Bid-Offer Spread As a Function of Quantity (Figure 24.1, page 539)

Offer Price

Bid Price

Quantity

100 units 500 or 1,000 units

Having many small positions instead of one large position, may reduce liquidity risk

Bid-Offer Spread (page 540-541)

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price BidpriceOffer spread,offer -Bid alProportion

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αs

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− =

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Bid-Ask Spread

p=20-15 = 5

S= (20-15)/17.5 = 29%

Unwinding a Position Optimally

• Relative to a large position: ➢Unwound quickly = large bid-ask spreads

➢But the loss from a mid-market price is small

➢Unwind the position over several days = smaller bid-ask spread

➢But the potential loss of mid-market price increases

Other Measures of Trading Liquidity

• Volume of trading per day = less liquidity: smaller volume

• Price impact of the size of a trade

• Absolute value of daily return divided by daily dollar volume (suggested by Amihud in 2002)

Research shows that an asset’s expected return increases as its liquidity decreases

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 (Business Snapshot 24.4, page 557)

• British Insurance Companies (Business Snapshot 3.1)

• LTCM (Business Snapshot 22.1)

➢Financial Crisis

➢Feb/ March 2020

Positive & Negative Feedback Trading

• Positive feedback: a trader buys after a price increase and sells after a price decrease ➢Following the market (trend following)

➢Momentum trading (breakout models)

➢Bubbles

➢Positive feedback trading may cause or accelerate a blackhole

• Negative feedback: trader buys after a price decrease and sells after a price increase ➢Contrarian

➢Buying bottoms & selling tops

➢Oversold or overbought sentiment

Causes for Positive Feedback Trading • Trading systems using stop orders

➢If the market goes down and hits your sell-stop order

➢If the market goes up and hits your buy-stop order

• Dynamic hedging a short option position ➢Buy after the prices rises and sells after the prices declines

➢Do the opposite for dynamic hedging of a long option = negative feedback

• Creating a long option position synthetically ➢Same activity as dynamic hedging a short option

• Margin calls ➢Due to leverage: forced to sell long positions or forced to buy

back short positions

Liquidity Funding Risk

• Liquidity funding risk ➢Solvency = more assets than liabilities?

➢But are you liquid?

➢Liquidity = quickly turn the assets into cash

➢Have enough cash on hand to meet your current obligations

➢Banks are required to have reserve requirements as percent of deposits. Large banks currently 10%

Liquidity Funding Risk

• Liquidity Sources • Cash and Treasury securities

• Ability to liquidate trading positions

• Ability to borrow: ➢lines of credit

➢Banks lending to each other

• Retail and wholesale deposits – has some volatility

• Securitization – “originate-to-distribute”

• Central bank borrowing –”lender of last resort”

Basel III Regulation

• Liquidity coverage ratio: designed to make sure that the bank can survive a 30-day period of acute stress

• Net stable funding ratio: a longer-term measure designed to ensure that stability of funding sources is consistent with the permanence of the assets that have to be funded

Liquidity

𝐿𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜

= 𝐻𝑖𝑔ℎ 𝑄𝑢𝑎𝑙𝑖𝑡𝑦 𝐿𝑖𝑞𝑢𝑖𝑑 𝐴𝑠𝑠𝑒𝑡𝑠

𝑇𝑜𝑡𝑎𝑙 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠 𝑜𝑣𝑒𝑟 30 𝐷𝑎𝑦𝑠

Examples of Liquidity Funding Problems • Northern Rock (Business Snapshot 24.1)

• Ashanti Goldfields (Business Snapshot 24.2)

• Metallgesellschaft (Business Snapshot 24.3)

The Leveraging Cycle (Figure 24.2)

Investors allowed to increase to leverage

They buy more assets

Asset prices increase

Leverage of investors decreases

The Deleveraging Cycle (Figure 24.3)

Investors required to reduce leverage

They do this is by selling assets

Asset prices decline

Leverage of investors increases

Thank You