Modeling Liquidity Risk: With Implications for Traditional Market Risk Measurement and Management

by Anil Bangia of Oliver, Wyman & Company,
Francis X. Diebold of the University of Pennsylvania & the Oliver Wyman Institute,
Til Schuermann of Oliver, Wyman & Company, and
John D. Stroughair of Oliver, Wyman & Company

December 21, 1998

Abstract: Market risk management under normal conditions traditionally has focused on the distribution of portfolio value changes resulting from moves in the mid-price. Hence the market risk is really in a "pure" form: risk in an idealized market with no "friction" in obtaining the fair price. However, many markets possess an additional liquidity component that arises from a trader not realizing the mid-price when liquidating her position, but rather the mid-price minus the bid-ask spread. We argue that liquidity risk associated with the uncertainty of the spread, particularly for thinly traded or emerging market securities under adverse market conditions, is an important part of overall risk and is therefore an important component to model.

We develop a simple liquidity risk methodology that can be easily and seamlessly integrated into standard value-at-risk models, and we show that ignoring the liquidity effect can produce underestimates of market risk in emerging markets by as much as 25-30%. Furthermore, we show that the BIS inadvertently is already monitoring liquidity risk, and that by not modeling it explicitly and therefore capitalizing against it, banks will be experiencing surprisingly many violations of capital requirements, particularly if their portfolios are concentrated in emerging markets.

Published in: Risk Management: The State of the Art, Vol. 8, (2002), pp. 3-13.

Published in abridged form as: "Liquidity on the Outside," RISK, Vol. 12, No. 6, (June 1999), pp. 68-73.

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