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OIRM-3-estimating-liquidity-risks.html
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<!doctype html>
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<title>Operational and Integrated Risk Management | Chapter 3 | Estimating Liquidity Risks</title>
<meta name="description" content="Financial Risk Manager Part 2 Study Materials">
<meta name="author" content="MacLane Wilkison">
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<h1>Chapter 3</h1>
<h3>Estimating Liquidity Risks</h3>
<p>
<small>Created for <a href="http://alchemistsacademy.com">Alchemists Academy</a> by <a href="http://alchemistsacademy.com/about">MacLane Wilkison</a></small>
</p>
</section>
<section>
<h2>Liquidity and Liquidity Risks</h2>
<ul>
<li>Liquidity refers to a trader's ability to execute a trade or liquidate a position</li>
<li>Depends on the number of traders in the market, frequency and size of trades, time to carry out a trade, and cost of transacting</li>
<li>Bid-ask spread and market price</li>
</ul>
<aside class="notes">
The bid-ask spread denotes the price a security may be sold (bid) or purchased (ask). The market price is a fictional price that is the average of the bid and ask.
</aside>
</section>
<section>
<h2>Estimating Liquidity-Adjusted VaR</h2>
<ul>
<li>Constant spread approach</li>
<ul>
<li>Liquidity cost (LC) = 0.5 × spread × P</li>
<li>LVaR = VaR + LC
</ul>
<li>Exogenous spread approach</li>
<ul>
<li>Assumes that traders face random spreads and uses Monte Carlo simulation to estimate the LVaR</li>
</ul>
<li>Endogenous-price approaches</li>
<ul>
<li>Accounts for market's response to a trade</li>
<li>Can easily be added to an exogenous spread approach</li>
</ul>
<li>Liquidity discount approach</li>
</ul>
<aside class="notes">
Constant spread approach: Spread = actual spread divided by the midpoint and P = the size of position to be liquidated. The liquidity discount approach suggests three modifications to traditional VaR: (1) use an optimal holding period rather than an arbitrary one; (2) Add the average liquidity discount to the trader's losses to account for the expected loss of the selling process; (3) account for the volatility of the time to liquidation and of the liquidity discount factor.
</aside>
</section>
<section>
<h2>Estimating Liquidity at Risk (LaR)</h2>
<ul>
<li>LaR refers to the risk attached to prospective cash flows over a defined horizon period</li>
<li>Maximum likely cash outflow over the period at a given confidence level</li>
<li>Common types of cash flows to consider:</li>
<ul>
<li>Known certain cash flows</li>
<li>Unknowns uncertain cash flows</li>
<li>Conditional uncertain cash flows</li>
</ul>
</ul>
</section>
<section>
<h1>THE END</h1>
<h3><a href="http://alchemistsacademy.com">AlchemistsAcademy.com</a></h3>
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