Aug 30

Liquidity risk: Definitions (2007 FRM)

by David Harper, CFA, FRM, CIPM

FRM | Risk |

liquidityIntro1

Learning Outcomes

  • LO 20.1: Explain the interrelationship between funding liquidity risk and market liquidity risk.
  • LO 20.2: Describe alternative methods for measuring liquidity risk.

What is liquidity risk?

In the FRM, liquidity risk is a component of market risk. Exact definitions may vary, but liquidity is always about a lack of time. To be illiquid is to need more time: funds are coming (but not soon enough) or the asset can be sold (but not immediately without pain).

It is important to see the difference between credit risk and market risk. Consider a typical asset-based commercial paper (ABCP) conduit. In an ABCP, the asset-backed securities (ABS) issued to investors are often collateralized by trade receivables. Liquidity risk is here an issue. The receivables may be high-quality, but they do not pay interest nor according to a maturity schedule; while the special-purpose entity (SPE) waits for these unscheduled, non-interest bearing, lumpy cash flows, it may owe scheduled, short-term, floating-rate liabilities to investors. Over the long run, the structure may be well-funded with perfectly manageable credit risk. But, in the short-run, a structural liquidity mismatch is entirely possible. In this example, credit risk is low but liquidity risk is high.

As elsewhere in the FRM, keep in mind that separate risks can still be (casually) interrelated. Credit risk is distinct from market risk, but if a counterparty defaults and creates a cash flow problem, credit risk creates liquidity problems.

Funding compared to market liquidity risk (20.1)

image image

Funding liquidity risk is an operational problem for the corporate Chief Financial Officer (CFO). It is also called solvency. Market liquidity risk is a funding problem in the capital markets, perhaps the problem of Corporate Treasury or a trader. Compare these to their equivalents in the Chartered Financial Analyst (CFA) program:

  • Funding liquidity risk = Internal Liquidity Risk (solvency). Metrics include current ratio (current assets/current liabilities) and quick ratio (liquid current assets/current liabilities)
  • Market liquidity risk = External Liquidity Risk . Metrics include trading turnover (percentage of shares traded over some period)

 

Metrics: Liquidity gap and LRE (20.2)

Culp discusses two liquidity risk metrics:

  • Liquidity Gap. This is simply net liquid assets: liquid assets (e.g.,  cash, cash equivalents) minus volatile (non-stable) liabilities.
  • Liquidity risk elasticity (LRE). This is the change in net assets over funded liabilities that is associated with a an increase in the marginal funding cost

lre

 

LRE is a first-order partial derivative.  The denominator is a spread. So, given a small increase in the spread (i.e., funding cost to the firm), the metric estimates the corresponding change to the firm's net liquid asset. The greater this sensitivity (of net liquid assets to increases in funding cost), the greater the LRE.

LRE has the same weaknesses that we see with the other first-order partial derivatives (i.e., duration, option delta):

  • LRE is a locally-accurate approximation. The greater the spread increase, the less accurate LRE
  • LRE assumes a parallel shift in the funding cost across maturities

Comments

  1. Be the first to leave a comment!

Leave a Comment