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Improper Mapping Understates Liquidity Risk

Thread starter #1
Hi David / Shakti,

Liquidity Risk - The risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. (Investopedia)

eg. Convertible bonds can be mapped to Risk factors including Implied Volatilities, Credit spreads, Int rates...based on the theoretical price of the convertible bond using a replicating portfolio...This is seems more like a pricing model to me.

How does this increase liquidity risk??

It could increase model risk or may be market risk...but liquidity risk does not seem to fit in here.

Would appreciate if anyone could explain

Thanks.
Hardy.
 
#2
In this scenario, we are underestimating the liquidity risk in the market. By marking to model we are making liquidity assumptions that may not hold. As a result, if the model assumes a liquid market, it may spit out a better price than we can get in a market where liquidity is scarce.

Here is the full text from that paragraph (emphasis mine):

Another example is convertible bond trading. Convertible bonds can be mapped to a set of risk factors including implied volatilities, interest rates, and credit spreads. Such mappings are based on the theoretical price of a convertible bond, which is arrived at using its replicating portfolio. However, theoretical and market prices of converts can diverge dramatically. These divergences are liquidity risk events that are hard to capture with market data, so VaR based on the replicating portfolio alone can drastically understate risk. Stress testing can mitigate the problem
 
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