Liquidation Risk

by Darrell Duffie of Stanford University, and
Alexandre Ziegler of the University of Lausanne

August 20, 2001

Introduction: The turmoil in financial markets in late 1998 accompanied a sharp decrease in market liquidity. Some financial institutions faced unexpectedly high bid-ask spreads when liquidating positions. This paper is an analysis of the effect on key risk measures (such as the likelihood of insolvency, value at risk, and expected tail loss) of bid-ask spreads that are likely to widen just when positions must be liquidated in order to maintain capital ratios, thus triggering additional losses. Our results show that illiquidity causes significant increases in risk measures, especially if spreads are negatively correlated with asset returns.

A potential strategy is to liquidate illiquid assets earlier, keeping a cushion of cash or liquid assets for "rainy days." Our results show that, although this approach is usually effective, it tends to increase expected trading costs, and may fail when asset returns and bid-ask spreads have fat tails.

Published in: Financial Analysts Journal, Vol. 59, No. 3, (May-June 2003), pp. 42-51.

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