Liquidity risk managment

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Liquidity risk managment

Liquidity risk managment

Types[ edit ] Market liquidity — An asset cannot be sold due to lack of liquidity in the market — essentially a sub-set of market risk. Cannot be met when they fall due Can only be met at an uneconomic price Can be name-specific or systemic [1] Causes[ edit ] Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade for that asset.

Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade. Manifestation of liquidity risk is very different from a drop of price to zero.

In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other.

Liquidity risk is financial Liquidity risk managment due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution.

A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. Market and funding liquidity risks compound each other as it is difficult to sell when other investors face funding problems and it is difficult to get funding when the collateral is hard to sell.

If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its Liquidity risk managment risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day.

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If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk.

A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk example—the two payments are offsetting, so they entail credit risk but not market risk. Another example is the Metallgesellschaft debacle. Futures contracts were used to hedge an Over-the-counter finance OTC obligation.

It is debatable whether the hedge was effective from a market risk standpoint, but it was the liquidity crisis caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions. Accordingly, liquidity risk has to be managed in addition to market, credit and other risks.

Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset liability management can be applied to assessing liquidity risk.

A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern.

Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults. Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities.

If an organization's cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general approach using scenario analysis might entail the following high-level steps: Construct multiple scenarios for market movements and defaults over a given period of time Assess day-to-day cash flows under each scenario.

Because balance sheets differ so significantly from one organization to the next, there is little standardization in how such analyses are implemented. Regulators are primarily concerned about systemic implications of liquidity risk. Pricing[ edit ] Risk-averse investors naturally require higher expected return as compensation for liquidity risk.

What is liquidity management? | Investopedia

The liquidity-adjusted CAPM pricing model therefore states that, the higher an asset's market-liquidity risk, the higher its required return. The excess value of the firm's liquid assets over its volatile liabilities.

A company with a negative liquidity gap should focus on their cash balances and possible unexpected changes in their values. As a static measure of liquidity risk it gives no indication of how the gap would change with an increase in the firm's marginal funding cost.

Elasticity[ edit ] Culp denotes the change of net of assets over funded liabilities that occurs when the liquidity premium on the bank's marginal funding cost rises by a small amount as the liquidity risk elasticity.

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For banks this would be measured as a spread over libor, for nonfinancials the LRE would be measured as a spread over commercial paper rates. Problems with the use of liquidity risk elasticity are that it assumes parallel changes in funding spread across all maturities and that it is only accurate for small changes in funding spreads.

Measures of asset liquidity[ edit ] Bid-offer spread[ edit ] The bid-offer spread is used by market participants as an asset liquidity measure. To compare different products the ratio of the spread to the product's bid price can be used. The smaller the ratio the more liquid the asset is.This is a research report on HDFC BANK PROJECT by Rakesh Rajdev in Finance category.

Search and Upload all types of HDFC BANK PROJECT projects for MBA's on Liquidity risk is the risk to an institution’s financial condition or safety and soundness arising from its inability (whether real or perceived) to meet its contractual obligations. The primary role of liquidity-risk management is to (1) prospectively assess the need for funds to meet obligations and (2) ensure the availability of cash or collateral to fulfill those needs at the appropriate time by coordinating the various sources of funds available to the institution under normal and stressed conditions.

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Hold the liabilities of traditional intermediaries, such as banks, thrifts, and insurance companies. This means holding savings accounts, money market deposit accounts (MMDAs), and so forth. Advisory BenchMatrix specializes in helping organizations in the development of institutional governance, risk and compliance frameworks, conducting gap analyses and process reviews to help identify and assess risks and recommend action plans to address control weaknesses.

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