Factoring liquidity risk into VAR

Instead of considering liquidity risk separately, it often makes sense to integrate it with market and credit risk. In simple terms, adverse market movements can lead to liquidity problems in terms of funding. If this triggers off asset sales, it leads to asset liquidity problems. Similarly, a lowering of the credit rating may result in the need to deposit more collateral or margin. This in turn may lead to liquidity problems. So liquidity risk must be integrated into VAR models so that risk measures pay sufficient attention to liquidity. A simple way to do this is by looking at a bid-ask spreads.

Bid – ask spreads are driven by:

Order processing costs, which tend to decrease with volumes
Asymmetric information costs
Inventory carrying costs.

High spreads often mean the markets are shallow and liquidity is lacking.

Liquidity adjusted VAR can be calculated by adding sa/2 for each position in the book, where a is the dollar value of the position and s is defined as (offer price – bid price) / mid-price.

Liquidity risk can also be factored into VAR measures by ensuring that the horizon is at least greater than an orderly liquidation period. Generally, the same horizon is applied to all asset classes, even though some assets may be less liquid than others. Alternatively, by increasing the time horizon, the capital requirement can be enhanced. Thanks to more capital, a financial institution will be better placed to deal with a severe liquidity crisis. Sometimes, longer liquidation periods for some assets are taken into account by artificially increasing the volatility. This again leads to a higher capital buffer.