Modeling Liquidity Risk: With Implications for Traditional Market Risk Measurement and Management
by Anil Bangia 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.
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.