LIQUIDITY RISK

Chapter 24: Risk Management and Financial Institutions, John C. Hull

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1. OVERVIEW
Distinguish solvency from liquidity:
Solvency: a company having more assets than liabilities.
Liquidity: the ability of a company to make cash payments as they
become due.
Financial institutions that are solvent can fail because of liquidity
problems.
Example: a bank whose assets are mostly illiquid mortgages.
Suppose the assets are financed 90% with deposits and 10% with
equity.
The bank is comfortably solvent.
But it could fail if there is a run on deposits with 25% of depositors
suddenly deciding to withdraw their funds.
(the case of Northern Rock)
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1. OVERVIEW
 A financial institution should assess a worst-case liquidity
scenario and make sure that it can survive that scenario by either
converting assets into cash or raising cash in some other way.
 In trading: a liquid position in an asset is one that can be
unwound at short notice.
As the market for an asset becomes less liquid, traders are more
likely to take losses because they face bigger bid–offer spreads.

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1. LIQUIDITY TRADING RISK

For 100,000 shares in IBM, liquidity risk is not a concern.

Several million IBM shares trade on the New York Stock Exchange
every day.
$100 million investment in the bonds of a noninvestment-grade
U.S. company might be quite difficult to sell at close to the market
price in one day.
Shares and debt of companies in emerging markets are even less
easy to sell.

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 Emerging markets, also known as emerging

economies or developing countries, are
nations that are investing in more productive
capacity. Leaders of developing countries
want to create a better quality of life for their
people. They are rapidly industrializing and
adopting a free market or mixed economy.
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1. LIQUIDITY TRADING RISK
The price at which a particular asset can be sold depends on:
1. The mid-market price of the asset, or an estimate of its value
2. How much of the asset is to be sold
3. How quickly it is to be sold
4. The economic environment

 A particular quote is good for trades up to a certain size.

 Above that size, the market maker is likely to increase the bid–offer
spread.
(bid–offer spread for an asset can vary from 0.05% of the asset’s mid-
market price to as much as 5%, or even 10%, of its mid-market price.)

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1. LIQUIDITY TRADING RISK

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1. LIQUIDITY TRADING RISK
 Figure 24.1 describes the market for large deals between
sophisticated financial institutions: The bid price tends to
decrease and the offer price tends to increase with the size of a
trade.
 Bid–offer spreads in the retail market sometimes show the
opposite pattern to that in Figure 24.1.
For example: an individual who approaches a branch of a bank
wanting to do a foreign exchange transaction or invest money
for 90 days.
 As the size of the transaction increases, the individual is likely
to get a better quote.

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1. LIQUIDITY TRADING RISK
The price that can be realized for an asset often depends on how
quickly it is to be liquidated and the economic environment.
(Sometimes, to sell the house immediately, the asking price will
have to be reduced well below the estimated market value).
Sometimes liquidity is tight (after the Russian default of 1998 or
after the subprime crisis of 2007–2008), liquidating even a
relatively small position can then be time-consuming and is
sometimes impossible.

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1. LIQUIDITY TRADING RISK
Liquidating a large position can be affected by what is termed
predatory trading.

Predatory trading is a strategy in which a trader can profit by

trading against another traders position, driving an otherwise
solvent but distressed trader into insolvency.

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Example: Company X has a large position and other

market participants guess that it will have to be unwound in
the near future.
The other market participants attempt to profit by doing
similar trades to those they expect from Company X.
Say, if it is expected that Company X will have to sell a
large position in a particular stock, they short the stock in
anticipation of a price decline.
more difficult than it would otherwise be for Company X
to exit from its position at competitive prices.
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1. LIQUIDITY TRADING RISK
 To avoid predatory trading, financial institutions emphasize to
employees the importance of keeping their positions and their
future trading plans confidential.
 Another problem: when one financial institution finds that it needs
to unwind a position, it is often that many other financial
institutions with similar positions need to do the same thing. The
liquidity normally present in the market then evaporates.
 “liquidity black hole” phenomenon

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1. LIQUIDITY TRADING RISK
BUSINESS SNAPSHOT 24.3: Metallgesellschaft
In the early 1990s, Metallgesellschaft (MG) sold a huge volume of 5
to 10 year heating oil and gasoline fixed-price supply contracts to its
customers at to 6-8 cents above market prices.
It hedged its exposure with long positions in short-dated futures
contracts that were rolled forward.
As it turned out, the price of oil fell and there were margin calls on
the futures positions.
MG’s trading was made more difficult by the fact that its trades were
very large and were anticipated by others.

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BUSINESS SNAPSHOT 24.3: Metallgesellschaft
Considerable short-term cash flow pressures were placed on MG.
The members of MG who devised the hedging strategy argued that
these short-term cash outflows were offset by positive cash flows
that would ultimately be realized on the long-term fixed-price
contracts.
However, the company’s senior management and its bankers became
concerned about the huge cash drain.
As a result, the company closed out all the hedge positions and
agreed with its customers that the fixed-price contracts would be
abandoned. The outcome was a loss to MG of $1.33 billion.

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The Importance of Transparency
Learned from the credit crisis of 2007: transparency is important for
liquidity.
If the nature of an asset is uncertain, it is not likely to trade in a liquid
market for very long.
Liquidity for the products soon disappears. When the products do trade
again, prices are likely to be low and bid–offer spreads are likely to be high.
Example: After August 2007: Financial institutions realized that they had
purchased highly complicated credit derivatives and lacked both the
necessary models and solid information about the assets in the portfolios
underlying the derivatives
(July 2008 Merrill Lynch agreed to sell $30.6 billion of ABS CDO tranches
(previously rated AAA) to Lone Star Funds for 22 cents/$1)

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1. LIQUIDITY TRADING RISK
Measuring Market Liquidity: normal market condition
Use bid–offer spread
The dollar bid–offer spread: p = Offer price − Bid price
The proportional bid–offer spread for an asset is defined as

=> In liquidating a position in an asset, a financial institution incurs a

cost equal to sα∕2 where α is the dollar (midmarket) value of the
position (the fact that trades are not done at the midmarket price).
Cost to liquidate the book in normal market conditions within a
certain time:

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1. LIQUIDITY TRADING RISK
Measuring Market Liquidity: normal market condition
Suppose that a financial institution has bought 10 million shares
($89.5 - $90.5) and 50 million ounces of a commodity($15 - $15.1).
The mid-market value in the shares: 90 × 10 = $900 m.
The mid-market value in the commodity: 15.05 × 50 = $752.50 m.
The proportional bid–offer spread for the shares: 1∕90 or 0.01111.
The proportional bid–offer spread for the commodity: 0.1∕15.05 or
0.006645.
The cost of liquidation in a normal market:
900 × 0.01111∕2 + 752.5 × 0.006645∕2 = 7.5 or $7.5 million.

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Measuring Market Liquidity: stressed market condition:

Define μi and σi as the mean and standard deviation of the

proportional bid–offer spread for the ith financial instrument held,
The parameter λ gives the required confidence level for the spread.

Example: we are interested in considering “worst case” spreads that

are exceeded only 1% of the time, and if it is assumed that spreads
are normally distributed, then λ = 2.326.

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Measuring Market Liquidity: stressed market condition:
Example: considering the previous case, suppose that the mean and
standard deviation for the bid–offer spread for the shares are $1.0 and
$2.0, respectively, and for the commodity are both $0.1.
The proportional mean and standard deviation in bid–offer spread for
the shares are 0.01111 and 0.02222
The proportional mean and standard deviation in bid–offer spread for
the commodity are both 0.006645.
Assuming the spreads are normally distributed, for 99% confident,
the cost of liquidation will not exceed:
0.5 × 900 × (0.01111 + 2.326 × 0.02222)
+ 0.5 × 752.5 × (0.006645 + 2.326 × 0.006645) = 36.58
$36.58 million: almost five times the cost of liquidation in normal
market conditions.
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Measuring Market Liquidity:
The equation assumes that spreads in all instruments are perfectly
correlated.
This is not conservative: When liquidity is tight and bid–offer
spreads widen, they tend to do so for all instruments.
A financial institution should monitor changes in the liquidity of
its book by calculating the equations on a regular basis.
The bid–offer spread depends on how quickly a position is to be
liquidated: The equations are likely to be decreasing functions of
the time period assumed for the liquidation.

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1. LIQUIDITY TRADING RISK
Unwinding a Position Optimally:
Unwinding a large position in a financial instrument needs the best
trading strategy:
If the position is unwound quickly: large bid– offer spreads, but
potential loss from the mid-market price moving unfavorably is
small.
If it takes several days to unwind the position: lower bid–offer
spread, but potential loss from the mid-market price moving
unfavorably is larger.
(Normally, when a position is to be closed out over n days, more
than 1∕n of the position should be traded on the first day)

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2. LIQUIDITY FUNDING RISK
Liquidity funding problems at a financial institution can be caused
by:
1. Liquidity stresses in the economy (e.g., a flight to quality
during the 2007 to 2009 crisis): Investors are then reluctant to
provide funding in situations where there is any credit risk at all.
2. Overly aggressive funding decisions: There is a tendency for all
financial institutions to use short-term instruments to fund long-
term needs, creating a liquidity mismatch. (Financial institutions
need to ask themselves: “How much of a mismatch is too much?”)
3. A poor financial performance, leading to a lack of confidence:
This can result in a loss of deposits and difficulties in rolling over
funding.

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2. LIQUIDITY FUNDING RISK
When a company experiences severe liquidity problems, all three of
these often occurred at the same time.
The key to managing liquidity risk is predicting cash needs and
ensuring that they can be met in adverse scenarios.
Some cash needs are predictable.
Example: if a bank has issued a bond, it knows when coupons will
have to be paid.
Some cash needs are less predictable
Example: withdrawals of deposits by retail customers and
drawdowns by corporations on lines of credit that the bank has
granted, or possible defaults by counterparties in derivatives
transactions.

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2. LIQUIDITY FUNDING RISK
Sources of Liquidity
The main sources of liquidity for a financial institution are:
1.Holdings of cash and Treasury securities
2.The ability to liquidate trading book positions
3.The ability to borrow money at short notice
4.The ability to offer favorable terms to attract retail and wholesale
deposits at short notice
5.The ability to securitize assets (such as loans) at short notice
6.Borrowings from the central bank

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2. LIQUIDITY FUNDING RISK
Sources of Liquidity:
1. Holdings of cash and Treasury securities:
Excellent sources of liquidity but relatively expensive
Trade-off between the liquidity of an asset and the return it provides
(e.g. loans to corporations provide a higher rate of return)
A limit to the amount that can reasonably be held.
2. Liquidating Trading Book Positions:
Regularly quantify the liquidity of trading book to ensure the ability
to survive in stressed market conditions.
The analysis should be based on stressed market conditions, not
normal market conditions.

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2. LIQUIDITY FUNDING RISK
Sources of Liquidity:
3. Ability to Borrow:
Heightened aversion to risk in stressed market conditions, leading to
higher interest rates, shorter maturities for loans, even refusal to provide
funds.
Should monitor the assets that can be pledged as collateral for loans at
short notice.
4. Wholesale and Retail Deposits:
Wholesale deposits are a more volatile than retail deposits and can
disappear quickly in stressed market conditions.
Retail deposits are not very stable as it is very easy to compare interest
rates and make transfers via the Internet.
When one financial institution offers more attractive rates of
interest, others usually do the same => more difficult to raise fund.
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2. LIQUIDITY FUNDING RISK
Sources of Liquidity:
5. Securitization:
Rather than keeping illiquid assets such as loans on their balance sheet, banks have
securitized them.
After August 2007, investors decided that the securitized products were too risky, this
is no longer a viable strategy.
6. Central Bank Borrowing :
Central banks are often referred to as “lenders of last resort”: prepare to lend money
to maintain the health of the financial system.
Collateral has to be posted by the borrowers and the central bank typically applies a
haircut (i.e., it lends less than 100% of the value of the collateral) and may charge a
relatively high rate of interest.
Kept as secret by banks as it can be interpreted as a sign of financial difficulties
causing other sources of liquidity dry up.

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Bank for International Settlements, “Principles for Sound Liquidity Risk
Management and Supervision,” Sep 2008.
1. A bank is responsible for the sound management of liquidity risk: establish a robust
liquidity risk management framework. Supervisors should take prompt action to protect
depositors and to limit potential damage to the financial system.
2. A bank should clearly articulate a liquidity risk tolerance
3. Senior management should develop a strategy, policies, and practices to manage
liquidity risk in accordance with the risk tolerance and to ensure that the bank maintains
sufficient liquidity.
4. A bank should incorporate liquidity costs, benefits, and risks in all significant
business activities, thereby aligning the risk-taking incentives with the liquidity risk
exposures.

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5. A bank should have a sound process for identifying, measuring, monitoring, and controlling liquidity
risk: a robust framework for comprehensively projecting cash flows over an appropriate set of time
horizons.
6. A bank should take into account legal, regulatory, and operational limitations to the transferability of
liquidity.
7. A bank should establish a funding strategy that provides effective diversification in tenor of funding,
and regularly gauge its capacity to raise funds quickly from each source.
8. A bank should actively manage its intraday liquidity positions and risks to meet payment and
settlement obligations under both normal and stressed conditions.
9. A bank should actively manage its collateral positions, the legal entity and physical location where
collateral is held and how it may be mobilized in a timely manner.

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10. A bank should conduct stress tests on a regular basis to adjust its liquidity risk management strategies, policies,
and positions and to develop effective contingency plans.
11. A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing
liquidity shortfalls in emergency situations.
12. A bank should maintain a cushion of unencumbered, high-quality liquid assets to be held as insurance against a
range of liquidity stress scenarios.
13. A bank should keep participants informed judgment the soundness of its liquidity risk management framework
and liquidity position.

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2. LIQUIDITY FUNDING RISK
Recommendations for banks supervisors are:
Regularly perform a comprehensive assessment of a bank’s overall liquidity risk management framework and liquidity
position.
Monitor a combination of internal reports, prudential reports, and market information.
Intervene to require effective and timely remedial action by a
bank to address deficiencies in its liquidity risk management processes or liquidity position.
Communicate with other supervisors and public authorities, such as central banks, both within and across national
borders.

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3. LIQUIDITY BLACK HOLES
Positive and Negative Feedback Traders
In liquid markets, negative feedback traders dominate the trading: If asset prices get unreasonably low => move in and buy =>
demand that will restore the price to a more reasonable level. (and vice versa)
When positive feedback traders dominate the trading, market prices are likely to be unstable and the market may become one-
sided and illiquid: A price reduction causes selling, making prices falling further and more selling. (and vice versa)

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3. LIQUIDITY BLACK HOLES
Reasons for positive feedback trading:
1. Trend trading: Trend traders attempt to identify trends in an asset price: They buy when the asset price appears to be trending up and sell when it appears
to be trending down.
2. Stop-loss rules: Traders often have rules to limit their losses. When the price of an asset falls below a certain level, they automatically sell to limit the loss.
3. Dynamic hedging: as options traders maintain a delta-neutral position using dynamic hedging.
4. Creating options synthetically: Hedging a short position in an option is equivalent to creating a long position in the same option synthetically (and vice
versa).

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BUSINESS SNAPSHOT 24.4: The Crash of 1987
On Monday, Oct 19, 1987, the Dow Jones Industrial Average dropped by more than 20%, mainly caused by Portfolio insurance.
In October 1987, portfolios involving over $60 billion of equity assets were being managed with trading rules that were designed to synthetically create put
options: sold equities (or selling index futures) when the market declined and bought equities (or buying equity futures) when the market rose.
At least $12 billion sales, with only $4 billion done from Wed to Fri (14-16/10).
On Mon (19/10), this strategy made up almost 10% of the sales on the New York Stock Exchange, and that portfolio insurance sales amounted to 21.3% of all
sales in index futures markets.

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3. LIQUIDITY BLACK HOLES
BUSINESS SNAPSHOT 24.4: The Crash of 1987
The popularity of portfolio insurance schemes has declined significantly since 1987.
it is dangerous to follow a particular trading strategy—even a hedging strategy—when many other market participants are doing the same thing.
Quoted from a report on the crash:

“….Ironically, it was this illusion of liquidity which led certain similarly motivated investors, such as portfolio insurers, to adopt strategies which call for
liquidity far in excess of what the market could supply.”

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3. LIQUIDITY BLACK HOLES
Reasons for positive feedback trading:
5. Margins: A big movement in market variables, particularly for traders who are highly leveraged, may lead to margin calls that cannot be met
=> force to close out their positions.
6. Predatory trading: if traders know that there will be large sales, the price of the asset is likely to decrease => short the asset => reinforces the
price decline => price falling even further than it would otherwise do. (large positions must usually be unwound slowly).

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3. LIQUIDITY BLACK HOLES
Leveraging
When banks are awash with liquidity, they make credit easily available
credit spreads decrease
increases demand
prices of these assets (often pledged as collateral) rise
borrowing can increase further
further asset purchases
more borrowing throughout the economy.

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3. LIQUIDITY BLACK HOLES
Deleveraging
When banks are less liquid, they are more reluctant to lend money
credit spreads increase
decreases demand
prices of these assets (often pledged as collateral) decrease
Banks reduce line of credit
further asset sales
Further reduction in asset prices.

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24.1 What was the transparency

problem in the subprime crisis of
2007?
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An asset is quoted bid 50, offer

55.What does this mean? What is the
proportional bid–offer spread?
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Suppose that an investor has shorted

shares worth $5,000 of Company A and
bought shares worth $3,000 of Company
B. The proportional bid–offer spread for
Company A is 0.01 and the proportional
bid–offer spread for Company B is 0.02.
What does it cost the investor to unwind
the portfolio?
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Imagine an investor who has engaged in

short selling with shares valued at $5,000
from Company A and simultaneously
purchased shares worth $3,000 from
Company B. For Company A, the bid-offer
spread as a proportion of the share price
is 0.01, and for Company B, it's 0.02.
What would be the expense incurred by
the investor to reverse this portfolio?
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Suppose that in Problem before the bid–

offer spreads for the two companies are
normally distributed. For Company A the
bid–offer spread has a mean of 0.01 and a
standard deviation of 0.01. For Company
B the bid–offer spread has a mean of 0.02
and a standard deviation of 0.03. What is
the cost of unwinding that the investor is
95% confident will not be exceeded?
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Assume that in the previous scenario, the

bid-offer spreads for both companies follow
a normal distribution. For Company A, the
bid-offer spread has an average (mean) of
1% with a typical variation (standard
deviation) of 1%. Company B's bid-offer
spread, on the other hand, has an average
of 2% and a standard deviation of 3%. What
is the expense of unwinding the position that
the investor can be 95% certain will not
surpass?
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 Suppose that a trader has bought some illiquid

shares. In particular, the trader has 100 shares
of A, which is bid $50 and offer $60, and 200
shares of B, which is bid $25 and offer $35.
What are the proportional bid–offer spreads?
What is the impact of the high bid–offer spreads
on the amount it would cost the trader to unwind
the portfolio? If the bid–offer spreads are
normally distributed with mean $10 and standard
deviation $3, what is the 99% worst-case cost of
unwinding in the future as a percentage of the
value of the portfolio?
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 Let's consider a scenario where a trader holds illiquid

stocks. Specifically, the trader possesses 100 shares of
stock A, which is priced at $50 for buyers and $60 for
sellers, and 200 shares of stock B, which has a buying
price of $25 and a selling price of $35. What are the
relative bid-ask spreads for these stocks? What is the
impact of these wide bid-ask spreads on the cost the
trader would incur when trying to sell the entire portfolio?
If we assume that the bid-ask spreads follow a normal
distribution with an average of $10 and a standard
deviation of $3, what is the 99th percentile estimate of
the worst-case cost for liquidating the portfolio in the
future as a percentage of the portfolio's total value?
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1.What is liquidity risk, and why is it important

for financial institutions?
2. How can financial institutions assess their
liquidity risk?
3. What's the influence of central banks and
government actions on managing liquidity
risk?
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1. What is the bid-ask spread, and how is it

related to liquidity risk?
2. What role do market makers play in
managing liquidity risk?
3. Why is it important for financial
institutions and investors to actively
manage liquidity risk?