 Understanding and Monitoring the Liquidity Crisis CycleRichard Bookstaber Financial Analysts Journal, 2000, vol. 56, issue 5, 17-22 Abstract: Commonly used tools are limited for assessing the risk of a liquidity crisis; an alternative considers hedge fund risk, leverage, and effective liquidity. A market crisis is not simply a “bad draw” from the distribution of day-to-day price moves. The genesis and dynamics of market crises have little to do with the information and the market flows that affect prices on typical days. A market crisis is a crisis of liquidity far more than it is a crisis born of surprising information.The characteristics that lead to potential crises do not rest entirely with the ability of a fund to take open-ended leverage or with its ability to take large risks or invest in illiquid markets. If a fund is highly levered but is in instruments that have low risk and high liquidity, the fund not only poses little risk to the market, it poses little risk to its investors. If it is in risky instruments but is unlevered, the fund's failure may be unfortunate for the investors but it does not have systemic implications. If the fund is in very illiquid instruments but not levered and has stability of capital, it is no more of a concern than an insurance company that holds real estate in its portfolio.What matters is the cycle that begins with the confluence of risk, leverage, and illiquidity—risk of loss coupled with leveraged positions, resulting in a need to liquidate into a market that cascades downward in price because of the rise in liquidation orders and the reduction in liquidity providers. The first stage in a liquidity crisis cycle is a loss that acts as the triggering event. The second is a need to liquidate positions to meet creditors' margin requirements. The third is a further drop in the fund's asset value as the market reacts to the fund's attempts to sell in too great a quantity or too quickly for market liquidity to bear. The drop in prices caused by the need to liquidate precipitates a further decline in the fund's mark-to-market value and leads, in turn, to yet further liquidation for margin or redemption purposes.This article provides a qualitative description of these stages of a crisis and discusses the limitations of transparency and common risk measures—such as value at risk—for yielding insights into the crisis. For example, VAR is of limited value in assessing the risk of market crises because during a crisis, correlations between assets can change dramatically and unexpectedly, with the result that positions that were thought to be diversifying—or even hedging—end up compounding risk.I propose a simple ratio to test for vulnerability to a liquidity crisis: the ratio of risk to capital divided by the standard deviation of that ratio. The numerator measures the likelihood that a change in asset prices will require a liquidation of a fund's position. The denominator indicates how easily the market can absorb any liquidation and measures the ability and willingness of the fund managers to change its exposure. A high ratio suggests a high risk of crisis.The role of liquidity in market crises has not been widely studied. One reason is that the role is difficult to investigate empirically. Market and economic information is widely available, but liquidity demand and supply are not observable. The role of liquidity in market crises is also difficult to model analytically because it is fraught with the complexities inherent in any dynamic process. In addition, market behavior during a liquidity-based crisis can seem at odds with economic rationality; rather than being based on market information or economic relationships, price behavior during a liquidity crisis depends on who holds what and who must liquidate. Thus, the market dislocations of a liquidity-based crisis are not only unpredictable; they are not even drawn from a stable distribution. The distribution will change every time a fund changes its positions or leverage. Date: 2000 Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:taf:ufajxx:v:56:y:2000:i:5:p:17-22 Ordering information: This journal article can be ordered from Access Statistics for this article Financial Analysts Journal is currently edited by Maryann Dupes More articles in Financial Analysts Journal from Taylor & Francis Journals |
Is your work missing from RePEc? Here is how to contribute.
Questions or problems? Check the EconPapers FAQ or send mail to .
EconPapers is hosted by the
School of Business at Örebro University.