Liquidity Risk

The liquidity of a financial instrument is often overlooked, as investors strive to produce the best risk adjusted returns.  Market liquidity usually fluctuates, but may be extremely illiquid as investors rush toward the exits during adverse market conditions.  Despite the liquidity associated with US stocks and ETFs, traders may need to measure liquidity to properly analyze the risk reward of a trading strategy.

Managing portfolio risk, stems well beyond directional and non-directional, as managers look to mitigate both credit risks and liquidity risks.   Liquidity risk is the ability of a portfolio manager to unwind a position and generate cash in a timely and efficient manner. 

 Historically, there have been a number of events in the recent past that have created the need to analyze the liquidity and transparency of a portfolio.  For example, in 2008, even the very liquid Eurodollar contracts, which allow traders to hedge Libor, where relatively illiquid, due to the financial crisis and the inability of banks to lend to one another.  The volatility of the crucial product became so severe that money market funds priced below par.

Measuring Liquidity

Liquid products such as government bonds, large cap equities and currencies, have relatively tight bid offer spreads, which may allow an investor to enter and exit a position without significant slippage.  A bid-off spread is the different between where market markers will purchase a financial instrument, which is called the bid, and where market makers will sell a financial product, which is called the offer. These types of markets are relatively transparent, and finding liquid price action is readily available.

Certain types of assets, such as real-estate or loans, are less liquid and are more opaque than liquid markets.  Transactions on these types of assets can be few and far between, and the bid offer spread, may be very wide.  During the peak of the housing crisis, which is still ongoing, there were times when there was no bid at any price for houses and apartment buildings. 

Over the Counter Products

Non-liquid products are usually over the counter products which are traded under guidelines that are governed by the market participants themselves.  For example, many financial instruments that are over the counter instruments are governed by ISDA, the International Swaps Dealers Association. 

The guidelines give some semblance to the market environment.  Products may range from interest rate swaps, which may allow companies to hedge against specific interest rate exposures, to exotic options that are used to make sophisticated bets.  Many of these type of products may experience large bid offer spreads.

Most over the counter products are traded by market makers which are generally banks, investment banks, and large hedge funds.  The market may exist through exchanges such as the Chicago Mercantile Exchange or the Intercontinental Exchange, or a broker market that can be online or over the phone. 

Over the counter products cleared through the CME, have the protection of a large organization, that may generate margin reports that may mitigate the credit risk of a product, but will not necessarily eliminate the liquidity risk associated with these products.

Each position within a portfolio has specific liquidity and a cost associated with it to turn it into cash.  For example, a 5-year natural gas swap will have a larger bid/offer spread than shares of a large liquid stock such as Microsoft.

 Liquidity Risk Management

 

 

When evaluating the positions in a portfolio, a portfolio manager may create a liquidity risk profile in which reserves are calculated to accommodate positions.  This can be accomplished by examining historical bid offer spread on specific financial instruments.  Evaluating historical bid/offer spreads will allow the portfolio manager to create a “market risk reserve” in which capital is set aside when a position is entered, and released when a position is liquidated. 

Managing liquidity risk is an important concept that should be reviewed especially for any opaque portfolio.  Micro and macro stocks may qualify as equities that would have wide and opaque bid offer spreads.  A historical market risk reserve is a formula that evaluates historical bid offer spreads of specific assets to generate a pool of capital that can be removed from the portfolio profit and loss.  An example of how this works is as follows:

Let’s assume a portfolio manager purchases a macro cap stock that has a historical bid offer spread that is wide.  An investor may create a market reserve where a specific amount of capital is moved out of the portfolio to account for the lack of liquidity.  This reserve is added back to the portfolio when the position is closed out.  Investors should also be cognizant that larger positions may have an effect on the bid offer spread and in fact make it wider as the position becomes larger. 

The concept is similar to creating a margin.  Instead of posting initial margin to a futures broker, the portfolio manager creates an artificial margin account which insulates a portfolio manager from large slippage created by opaque products. 

The advantage of managing liquidity risk is that it employs some analytics on products that create losses when the portfolio manager exits a position.  The more volatile the market environment, the more difficult it can be to exit illiquid positions.  The disadvantage is that income is set aside to incorporate this type of risk management.

Summary

Liquidity risk is another form of risk that investors may need to be aware of before they create a strategy that employs illiquid assets.  Generally large cap stocks have tight bid offer spread, but as the size of a position increases, the slippage risks increases.  As an example, a position of 10,000 shares would barely budge the spread in Apple Inc., shares, but a position of a million shares that were sold all at once, may have a negative effect on price action.  Small cap stocks are usually susceptible to increased liquidity which is important to focus on prior to initiating a position.

 

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 This article is a guest blog written by easy-forex