Measures of Liquidity Risk

Risksvr™ handles  two methodologies to measure Liquidity Risk:

1. Cost-to-Close

   Cost-To-Close measures the additional risk associated with unwinding illiquid assets or large Positions in a liquid asset. Illiquid assets take more time to unwind, which impacts both on risk and cost of carry.
   The same holds true for large stakes in liquid equities or bonds as they must often be broken down into smaller, easier to manage, trades that will hopefully go unnoticed.
   To enable liquidity risk, Risksvr™ expects the liquidity field to contain the number of days you assume will be needed to unwind the position or the percentage amount that will be unwound per business day.
   

   The liquidity field can be defined at different levels of the Trade Hierarchy:

   • In any Trade. In the liquidity field of the Trade Envelope (Trade Header)
   • At the Portfolio Level, through the Tag's liquidity field. In the liquidity field of the Trade Enveloppe (Trade Header)
   • At the Global level, in the liquidity field of the Analysis Setup Realm.
   Note: The Liquidity Field must contain a value above 1 Day or Below 1.0 (100%) in order to trigger liquidity Risk computation.
   
   
   Cost-to-close can be integrated at different levels of the calculations:
   
   At the trade levels, the User Defined Tag level and at an overall level.
   
   The value contained in the Liquidity Tag impacts all connected trades with a liquidity Risk that is Lower than the liquidity value defined in the Tag.
   The value contained in the Liquidity field of the Analysis Setup impacts all trades with a liquidity Risk that is Lower than the liquidity value defined in the Analysis Setup.
   
   

2. As a stochastic measure of bid/ask spread price slippage

This advanced measure, computes the additional cost and risk by integrating in the simulation a stochastic Bid-Ask spread price slippeage.
This additional spread is then added to the assets projected value, which then impacts all other computed values.

Stochastic Bid-Ask spreads are computed at the trade level. There is no additional aggregation override at the Tag level.

This measurement requires a stochastic Bid-Ask spread definition. i.e. a mean spread and spread volatility either in Basis Points or Percentage

Cost-To-Close Setup

The Liquidity risk tab of the Analysis Setup Screen controls Liquidity Risk Computations.

To activate Liquidity Risk in your Reports you must:

• Check the Activate Liquidity Checkbox. This will display the Min Override (Minimum Override) in Days or Percentage control.
• Enter the minimum liquidity override for your analysis. This value is either defined in Days (default) or Percentage Amount depreciated every day.
  
  The default value is 1 day.
  You can however define any number of days up to a maximum of two weeks (i.e. 10 days).
  
  The minimum override defines the minimum number of days needed to unwind all active positions.

Trade Level Granularity:

You define the number of days needed to unwind your position at the trade level in the position trade header (also called Common Fields or Trade Envelope):

Liquidity is defined by the user as the number of days needed to unwind the position.
The engine then computes the additional cost and risk associated with carrying the position over these additional number of days.

Liquidity risk  breaks down the total outstanding amount  into equal portions over the number of days necessary to unwind the position. Although the depreciation is constant, Liquidity Risk is certainly not proportional as many factors can influence the final value. the most obvious that come to mind are:

•  Ageing: How the instrument ages over the additional time period until the position is completely removed from the books.
  This is especially important for time-sensitive assets such as short terms Money Market instruments, Options, financial futures, etc.
• Flows received or Paid, exercise of payoff,  accrued interest, etc.
• The cost of carry, which is determined by the Shape of the Yield Curve.
• Credit Events. etc.

Liquidity Risk is aggregated to the Total Risk Value(s) [Earnings at Risk, Value at Risk, Moments] of the last Simulation Step.