A LIQUIDATION RISK ADJUSTMENT FOR VALUE AT RISK AND EXPECTED SHORTFALL

Lakshithe Wagalath and Jorge P. Zubelli ()
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Lakshithe Wagalath: IESEG School of Management — LEM, (CNRS), 1 Parvis de la Défense, 92044, Paris La Défense Cedex, France†Instituto de Matematica Pura e Aplicada, Estr. Dona Castorina, 110, Jardim Botanico, Rio de Janeiro, RJ 22460-320, Brasil
Jorge P. Zubelli: #x2020;Instituto de Matematica Pura e Aplicada, Estr. Dona Castorina, 110, Jardim Botanico, Rio de Janeiro, RJ 22460-320, Brasil

International Journal of Theoretical and Applied Finance (IJTAF), 2018, vol. 21, issue 03, 1-21

Abstract: This paper proposes an intuitive and flexible framework to quantify liquidation risk for financial institutions. We develop a model where the “fundamental” dynamics of assets is modified by price impacts from fund liquidations. We characterize mathematically the liquidation schedule of financial institutions and study in detail the fire sales resulting endogenously from margin constraints when a financial institution trades through an exchange. Our study enables to obtain tractable formulas for the value at risk and expected shortfall of a financial institution in the presence of fund liquidation. In particular, we find an additive decomposition for liquidation-adjusted risk measures. We show that such a measure can be expressed as a “fundamental” risk measure plus a liquidation risk adjustment that is proportional to the size of fund positions as a fraction of asset market depths. Our results can be used by risk managers in financial institutions to tackle liquidity events arising from fund liquidations better and adjust their portfolio allocations to liquidation risk more accurately.

Keywords: Liquidation risk; fire sales; value at risk; expected shortfall; risk management; price impact (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (4)

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DOI: 10.1142/S0219024918500103

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