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Hi David,
I stumbled over the following two (confusingly) different calculations for the cost of liquidity (CoL): comparing the BIS equation (original paper: BCBS_wp19) on page 14 (http://www.bis.org/publ/bcbs_wp19.pdf) for exogenous liquidity and the formula used by K. Dowd (and in your spreadsheet with two different spread calculations):
Bangia (1999)proposes the formula:
CoL = V *{ (mu + deviate*sigma)/2 } where mu = (askbid)/mid price
However, looking at your spreadsheet where you simulate Dowd's LVaR it says the following for the CoL:
1. Constant spread:
the CoL is simply 1/2 times the mean spread. Referring to the Bangia formula, this would mean: 1/2 * mu
and would therefore yield a completely different CoL compared to the Bangia equation.
2. Random spread:
This is more similar to the Bangia equation, but with the little difference of replacing the normal deviate with 'k'
CoL = V* { (mu + k*sigma)/2 } where k equals a random number (3 in your case)
Why is the normal deviate in Dowd's LVaR (exogenous random spread) replaced with a random number (k)?
For the exam, is it enough to know the difference between the two equation's for LVaR given in Jorion (attached): 1. simple LVaR where we add 1/2 of the spread 2. worstcase LVaR with the extended formula?
Any input and discussion is highly appreciated!
Thank you!
I stumbled over the following two (confusingly) different calculations for the cost of liquidity (CoL): comparing the BIS equation (original paper: BCBS_wp19) on page 14 (http://www.bis.org/publ/bcbs_wp19.pdf) for exogenous liquidity and the formula used by K. Dowd (and in your spreadsheet with two different spread calculations):
Bangia (1999)proposes the formula:
CoL = V *{ (mu + deviate*sigma)/2 } where mu = (askbid)/mid price
However, looking at your spreadsheet where you simulate Dowd's LVaR it says the following for the CoL:
1. Constant spread:
the CoL is simply 1/2 times the mean spread. Referring to the Bangia formula, this would mean: 1/2 * mu
and would therefore yield a completely different CoL compared to the Bangia equation.
2. Random spread:
This is more similar to the Bangia equation, but with the little difference of replacing the normal deviate with 'k'
CoL = V* { (mu + k*sigma)/2 } where k equals a random number (3 in your case)
Why is the normal deviate in Dowd's LVaR (exogenous random spread) replaced with a random number (k)?
For the exam, is it enough to know the difference between the two equation's for LVaR given in Jorion (attached): 1. simple LVaR where we add 1/2 of the spread 2. worstcase LVaR with the extended formula?
Any input and discussion is highly appreciated!
Thank you!
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