Modeling Liquidity Risk, With Implications for Traditional Market Risk Measurement and Management

Bangia A., Diebold F.X. and other, Schuermann T., Stroughair J.D. — USA, Wharton Financial Institutions Center, 1998. — 18 p.Market risk management under normal conditions traditionally has focussed on the distribution of portfolio value changes resulting from moves in the mid-price. Hence the market risk is really in a pure form: risk in an idealized market with no friction in obtaining the fair price. However, many markets possess an additional liquidity component that arises from a trader not realizing the mid-price when liquidating her position, but rather the mid-price minus the bid-ask spread. We argue that liquidity risk associated with the uncertainty of the spread, particularly for thinly traded or emerging market securities under adverse market conditions, is an important part of overall risk and is therefore an important component to model.