B1 Intermediate US 730 Folder Collection
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Liquidity Risk In this short video, we will discuss liquidity
risk, how it is defined and how a portfolio manager handles the risk of owning specific
types of positions. Additionally we will discuss the advantages and disadvantages of employing
liquidity management. Managing portfolio risk beyond directional
and non-directional risks attempts to eliminate the risk that are based on the liquidity
of assets within the portfolio. Liquidity risk includes the ability of a portfolio manager
to unwind a position and generate cash in a timely and efficient manner. Historically,
there have been a number of events in the recent past that have created the need to
analyze the liquidity and transparency of a portfolio. For example, in 2008, even the
very liquid Eurodollar contracts, which allow traders to hedge Libor, where relatively illiquid,
due to the financial crisis and the inability of banks to lend to one another.
Liquid products such as government bonds, large cap equities and currencies, have relatively
tight bid offer spreads, which allow an investor to enter and exit a position without significant
slippage. A bid-off spread is the different between where market markers will purchase
a financial instrument, which is called the bid, and where market makers will sell a financial
product, which is called the offer. These types of markets are relatively transparent,
and finding liquid price action is readily available. Certain types of assets, such as real-estate
or loans, are less liquid and are more opaque than liquid markets. Transactions on these
types of assets can be few and far between, and the bid offer spread, can be very wide.
Non-liquid products are usually over the counter products which are traded under guidelines
that are governed by the market participants themselves. For example, many financial instruments
that are over the counter instruments are governed by ISDA, the International Swaps
Dealers Association. The guidelines give some semblance to the market environment. Products
can range from interest rate swaps, which allow companies to hedge against specific
interest rate exposures to exotic options that are used to make sophisticated bets.
Most over the counter products are traded by market makers which are generally banks,
investment banks, and large hedge funds. The market can exist through exchanges such as
the Chicago Mercantile Exchange or the Intercontinental Exchange, or a broker market that can be online
or over the phone. Each position within a portfolio has specific
liquidity and a cost associated with it to turn it into cash. For example, a 5-year natural
gas swap will have a larger bid/offer spread than shares of a large liquid stock such as
Microsoft. When evaluating the positions in a portfolio,
a portfolio manager should create a risk profile in which reserves are calculated to accommodate
a positions. Evaluating historical bid/offer spread will allow the portfolio manager to
create a "market risk reserve" in which capital is set aside when a position is entered, and
released when a position is liquidated. Managing liquidity risk is an important concept
that should be reviewed especially for any opaque portfolio. A historical market risk
reserve is a formula that evaluates historical bid offer spreads of specific assets to generate
a pool of capital that can be removed from the portfolio profit and loss. An example
of how this works is as follows: Let's assume a portfolio manager purchases
and over the counter product that has a historical bid offer spread that is wide. A portfolio
manager can create a market reserve where a specific amount of capital is moved out
of the portfolio to account for the lack of liquidity. This reserve is added back to the
portfolio when the position is closed out. The concept is similar to creating a margin
account for over the counter products. Instead of posting initial margin to a futures broker,
the portfolio manager creates an artificial margin account which insulates a portfolio
manager from large slippage created by opaque products.
The advantage of managing liquidity risk is that is employs some analytics on products
that create losses when the portfolio manager exits a position. The more volatile the market
environment, the more difficult it can be to exit illiquid positions. The disadvantage
is that income is set aside to incorporate this type of risk management.
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Liquidity Risk | CHP

730 Folder Collection
Jung Chen published on October 30, 2015
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