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

Anil Bangia, Francis Diebold, Til Schuermann and John D. Stroughair

New York University, Leonard N. Stern School Finance Department Working Paper Seires from New York University, Leonard N. Stern School of Business-

Abstract: Market risk management traditionally has focussed on the distribution of portfolio value changes resulting from moves in the midpoint of bid and ask prices. 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.

Date: 1998-12-21
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Working Paper: Modeling Liquidity Risk, With Implications for Traditional Market Risk Measurement and Management (1998)
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