Types And Causes Of Liquidity Risk Finance Essay

Types And Causes Of liquid state essay Finance EssayIn pay, fluidity state put on the lineis the stake that a presumption security or asset squeeze out non be dispensed quickly plentiful in the grocery store to prevent a loss (or subscribe the need profit).OR liquidness stake is the menstruum and prospective stake to mesh or great arising from a banks in strength to meet its obligations when they come repayable without incurring un congenial losses. Liquidity take a chance includes the inability to manage ignorant decreases or changes in patronage sources. Liquidity take a chance also arises from the misery to recognize or address changes in merchandise conditions that appropriate the ability to antipatheticact assets quickly and with minimal loss in value.2.1-Types of Liquidity gambleAsset tranquility Due to the inadequacy of runniness in merchandise an asset give nonice not be sold it is basi blackguardy subset of market run a lay on the line. Th is rout out be done byWidening bid/ twisting spreadMaking explicit fluidity reservesLengthening guardianship menses for Vary calculationsFunding liquid state guess that liabilityCannot be met when they fall dueCan only be met at an wasteful priceCan be name-specific or systemic2.2- Causes of Liquidity Risk in that respect be m whatsoever causes of liquid venture liquid luck actually arises when the one party wants to barter an asset cannot do it because in the market no one wants to trade that asset .The persons who atomic number 18 intimately to hold or currently hold the asset and want to trade that asset then liquidness endangerment get under(a) ones skin partial grievous to them as it affects their ability to do business.From regorge of price to zero is very different from that appearance of runniness risk. In the case when the assets price drop to zero then market said that asset is valueless. On the an opposite(prenominal) hand when one party found that t he other party is not interested in buying and merchandising of an asset then it sire a big problem for the participant of a market to expose the other interested party. So we can say that in the uphill markets or low volume markets the risk of fluidity is higher.Due to mutable fluidity the liquidness risk is known as a fiscal risk.When the reference work rating falls the institution whitethorn lose its liquidity, in this way rapid un judge interchange out adverts, or as a result of this happening the counterparties may avoid the business of buying and selling with or borrowing the loan to the institutions. A loyal is also opened to liquidity risk if markets on which it depends atomic number 18 subject to loss of liquidity. The firm is also giben to the risk of liquidity when the markets in they depend are under the liquidity loss.Liquidity risks tend to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate t hat position at short notice will compound its market risk. Let us suppose a firm has a hard currency flows offsetting on a given day of with deuce different counter parties. If the counter party do not make the payment and become a payment defaults. In this way firm will make believe to make the cash from some other sources in order to make payment. Credit risk is the risk arises due to the liquidity.A position can be hedged against market risk only when still stand for liquidity risk. This is true in the above credit risk example-the two payments are offsetting, so they entail credit risk but not market risk. Another example is the 1993Metallgesellschaftdebacle. Futures contracts were used to hedge an Over-the-counter finance OTC obligation. It is debatable whether the hedge was impressive from a market risk standpoint, but it was the liquidity crisis caused by staggering margin calls on the futures that obligate Metallgesellschaft to unwind the positions.As compared to the risks like market, credit and other risks the liquidity risk is also has to be managed. It is im come-at-able to isolate the liquidity risk because it has the magnetic dip to compound the other risks all overall the most simple circumstances. Liquidity risk does not exit in the comprehensive metrics. In order to assessed the liquidity risk the certain techniques of asset liability commission can be applied on a day by day basis. A simple test is conducted for the liquidity risk in ordered to see the net cash flows. all day which shows a sizeable invalidating cash flow is of concern.Analyses much(prenominal) as these cannot easily take into card contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organizations cash flows are magnanimously contingent, liquidity risk may be assessed exploitation some form of scenario depth psychology. A general get on using scenario analysis might entail the following high-level stepsConstruct dupl ex scenarios for market movements and defaults over a given period of time assess day-to-day cash flows under each scenario.Becausebalance sheetsdiffer so significantly from one organization to the next, at that place is undersize standardization in how such analyses are implemented.Regulators are primarily concerned to the highest degree systemic and implications of liquidity risk.2.3- Liquidity gapThe liquidity gap is the net liquid assets of a firm.As a static pace of liquidity risk it gives no indication of how the gap would change with an increase in the firms peripheral documentation make up.2.4- Liquidity risk elasticityCulp denotes the change of net of assets over funded liabilities that transcend when the liquidity premium on the banks marginal funding cost rises by a small amount as the liquidity risk elasticity. For banks this would be measured as a spread over libor, for non pecuniary the LRE would be measured as a spread over mercenary paper rates.Problems wit h the use of liquidity risk elasticity are that it assumes latitude changes in funding spread across all maturities and that it is only perfect for small changes in funding spreads.2.5- Measures of Asset LiquidityFollowing are the measures of asset liquidity.2.5.1. Bid-offer spreadThebid-offer spreadis used by market participants as an asset liquidity measure. To compare different products the ratio of the spread to the products middle price can be used. The smaller the ratio the more liquid the asset is.This spread is comprised of operational costs, administrative and butt oning costs as intumesce as the compensation necessitated for the possibility of trading with a more informed trader.2.5.2. Market depthHachmeister refers tomarket depthas the amount of an asset that can be bought and sold at sundry(a) bid-ask spreads.Slippageis related to the concept of market depth. Knight and Satchell mention a flow trader needs to consider the effect of executing a large order on the m arket and to adjust the bid-ask spread accordingly. They calculate the liquidity cost as the difference of the act price and the initial execution price.2.5.3. ImmediacyImmediacy refers to the time needed to success amply trade a certain amount of an asset at a prescribed cost.2.5.4. resilienceHachmeister identifies the fourth dimension of liquidity as the speed with which prices recurrence to reason levels after a large transaction. Unlike the other measures resilience can only be determined over a period of time.2.6- Managing Liquidity Risk2.6.1-Liquidity- set value at riskLiquidity-adjusted VAR incorporates exogenous liquidity risk intoValue at Risk. It can be defined at VAR + ELC (Exogenous Liquidity Cost). The ELC is the worst expected half-spread at a especial(a) confidence level.Another adjustment is to consider VAR over the period of time needed to liquidate the portfolio. VAR can be measured over this time period. TheBISmentions a number of institutions are exploring the use of liquidity adjusted-VAR, in which the holding periods in the risk assessment are adjusted by the length of time required to unwind positions.2.6.2-Liquidity at riskGreenspan (1999) discusses oversight of foreign exchange reserves. The Liquidity at risk measure is suggested. A countrys liquidity position under a range of mathematical outcomes for relevant financial variables (exchange rates, commodity prices, credit spreads, etc.) is considered. It might be possible to express a standard in terms of the probabilities of different outcomes. For example, an acceptable debt structure could have an average maturity averaged over estimated distributions for relevant financial variables in excess of a certain limit. In addition, countries could be expected to hold capable liquid reserves to ensure that they could avoid new(a) borrowing for one year with certain ex ante probability, such as 95 percent of the time.2.6.3-Scenario analysis-based contingency figuresThe FDIC discu ss liquidity risk management and write Contingency funding final causes should incorporate events that could rapidly affect an institutions liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty.Greenspans liquidity at risk concept is an example of scenario based liquidity risk management.2.6.4-Diversification of liquidity declare oneselfrsIf several liquidity providers are on call then if any of those providers increases its costs of supplying liquidity, the impact of this is reduced. The American academy of Actuaries wrote While a company is in good financial shape, it may wish to establish durable, ever-green (i.e., always available) liquidity lines of credit. The credit issuer should have an fittingly high credit rating to increase the chances that the resources will be at that place when needed.2.6.5-DerivativesThe fiv e derivatives that are discuss by bhaduri,meissner yon created specifically for hedge liquidity risk.Withdrawal survival of the fittest A put of the illiquid underlying at the market price.Bermudan-style return put selection Right to put the option at a specified strike.Return swap Swap the underlings return for LIBOR paid periodically.Return swaption Option to enter into the return swap.Liquidity option Knock-in barrier option, where the barrier is liquidity metric.otherFunding sources are spacious and provide a competitive cost advantage.Funding is widely diversified. There is little or no credit on in large quantities funding sources or credit-sensitive funds providers.Market alternatives exceed solicit for liquidity, with no obstinate changes expected.Capacity to augment liquidity through asset gross sales and/or securitization is strong and the Bank has an established record in accessing these markets.The volume of sell liabilities with embedded options is low.The Ba nk is not vulnerable to funding difficulties should a clobber adverse change occur in market perception.Support provided by the parent company is strong.Earnings and capital motion-picture show from the liquidity risk profile is negligible.-Quantity of Liquidity Risk IndicatorsIn order to assess the measure of liquidity risk the following indicator should be used. Every trace is not necessary to be demonstrated.2.7.1-LowThe sources of funding are abundant and provide a advantage of competitive cost.Funding is mostly flourished. There is little or no reliance on sweeping funding sources or other credit-sensitive funds providers. On the sources of wholesale funding or others providers of credit sensitive fund in it there is no trust.The demand for liquidity goes above by the market alternatives and there are no any expected changes.Capacity to augment liquidity through asset sales and/or securitization is strong and the Bank has an established record in accessing these markets.Th e wholesale liabilities have a low volume with fixed options.The Bank is not weak to funding difficulties should a material adverse change occur in market perception.The parent company provides the support which is strong.Earnings and capital exposure from the liquidity risk profile is negligible.2.7.2-ModerateThe funding sources which are sufficient are available that provides a liquidity which is cost effective.Funding is generally expanded, by a few providers that may share their common objectives and their sparing influences, but no significant concentrations. The wholesale funding is clear and it has a modest reliance. The market alternatives that is available in order to meet the demand for liquidity on reasonable terms.The Bank possesses the potential might to expand liquidity through asset sales and/or securitization. The bank has a modest experience in order to access these marketsSome wholesale funds catch embedded options, but potential impact is not significant.The Ba nk is not excessively vulnerable to funding difficulties should a material. the decent support is provided by the parent company.Earnings or capital exposure from the liquidity risk profile is manageable.2.7.3-HighFunding sources and liability structures suggest current or potential difficulty in maintaining long-term and cost-effective liquidity. get sources may be concentrated in a few providers or providers with common investment objectives or economic influences. A significant reliance on wholesale funds is evident.Liquidity needs are increasing, but sources of market alternatives at reasonable terms, costs, and tenors are declining.The Bank exhibits little capacity or potential to augment liquidity through asset sales or securitization. A lack of experience accessing these markets or unfavorable written report may make this option questionable.Material volumes of wholesale funds contain embedded options. The potential impact is significant.The Banks liquidity profile makes it vulnerable to funding difficulties should a material adverse change occur.Parent company provides a little or unknown support.Potential exposure to loss of compensation or capital due to high liability costs or unplanned asset reduction may be substantial.Liquidity risk managementAchieving best practiceManaging liquidity risk is often about applied common sense, like operational risk it requires a firm-wide approach and this places a high demand on the right regalees and procedures.Any management information system used to mitigate liquidity risk should beAccurateThe best way of encouraging accuracy is to keep reportage simple.CommunicativeReport and information should speak plainly.RegularTimely insurance coverage allows managers to judge changes in the market and their organizations liquidity profile.ComprehensiveMust resound your organizational reality, such as different entities, jurisdictions and regulations.RealisticScenario must be pixilated if risk is to be identified in real situations.2.8-Quality of Liquidity Risk ManagementThe following indicators, as appropriate, should be used when assessing the look of liquidity risk management.2.8.1-StrongThe polices are approved by the board and advance guidelines effectively for the liquidity risk management and responsibilities are designated.The liquidity risk management process is effective in identifying, measuring, monitoring, and controlling liquidity risk. The process of liquidity risk management is effective for identifying liquidity risk, for measuring, monitoring, and controlling the liquidity risk.A sound culture reflects that has provenLiquidity risk is fully understood by the management in all the aspects.Management anticipates and replys well to changing market conditions.The contingency funding plan is well-developed, effective and useful. The plan incorporates reasonable assumptions, scenarios, and crisis management planning, and is tailored to the needs of the institution.Management i nformation systems focal point on significant issues and produce timely, accurate, complete, and meaningful information to enable effective management of liquidity.Internal audit is comprehensive and effective.The scope and frequency are reasonable.2.8.2-SatisfactoryPolices are approved by the Board which communicate adequately counselling for liquidity risk management and responsibilities are assigned.There may be a minor weakness present.The liquidity risk management process is generally effective in identifying, measuring, monitoring, and controlling liquidity.There may be minor weaknesses given the complexity of the risks undertaken, but these are easily corrected..the blusher aspects of liquidity risk are reasonably understands by the management.Management adequately responds to changes in market conditions when changes occur in the market conditions the management respond adequately.The plan of contingency funding is adequate.The plan is current, reasonably addresses most relevant issues, and contains an adequate level of detail including multiple scenario analysis.The plan may require minor refinement.Management information systems adequately capture concentrations and rollover risk, and are timely, accurate, and complete.Recommendations are minor and do not impact effectiveness.Internal audit is reasonable.Any weaknesses are minor and do not impair effectiveness or reliance on audit findings.2.8.3-WeakThe Board has approved policies which are insufficient or incomplete.In one or more material value the policy is incomplete.the process of liquidity risk management is vain in identifying, monitoring and controlling the liquidity riskThis may be true in one or more material respects, given the complexity of the risks undertaken. The liquidity risk does not fully understand by the management. In the conditions when the market changes the management does not take any timely or suitable actions and do not participate. .The contingency funding plan is in adequate or nonexistent.The plan may not consider cost-effectiveness or availability of funds in a non-investment grade or CAMEL 3 environment.The information systems of management are deficient. The plan may be there but they do not adopted by the institutions, it is not reasonable, or they are not implemented as it should be.The information which is material may be a incomplete or lacking.Due to one or more material deficiencies the internal auditor coverage is missing or useless.2.9-Common problems and misconceptionsLiquidityriskis one of the least understood and most underestimated risks that financial markets participants are exposed to.Reasons for this include Under normal market conditions,liquidityproblems are not observed Liquidityriskdoes not carry itself to readily usable measures Despite specific BIS recommendations,liquidityriskmanagementis left out of capital adequacy calculations due to a lack of control and regulation Liquiditymanagement is often confused with liqui dityriskmanagement Market and creditriskmanagement taper on assets, whileliquidityrisk can stem from liabilities as wellLiquidityriskis also different in temperament to market and creditriskand needs to be thought of other than Normal markets analyses (expected or going-concern situations) are insufficient liquidityriskcan only be understood with scenario-based stress testing Historical measures ofliquidityare irrelevant prospective views are essential Liquidityriskcannot be readily hedged, and can only be militated against through rigorous monitoring and controls The pricing of many instruments does not properly charge forliquidity.