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Market Liquidity and Its Risk

An Overview

Sebastian Stange and Prof. Christoph Kaserer


Chair of Financial Management and Capital Markets
Technische Universität München
Arcisstr. 21
D-80290 München
Tel.: +49 89 / 289 - 25485
Mail: Sebastian.Stange@wi.tum.de
URL: www.ifm.wi.tum.de
Presentation aims to convey state of research on market liquidity
Goals of this presentation

• Practitioners
• Quick introduction to important
aspects and developments
• Students
• Summary of current state of research for
• Researchers
• Starting point for further research
• Those interested

General financial background required

Sebastian Stange and Christoph Kaserer, Chair of Financial Management and Capital Markets 2

Market liquidity v090127b.ppt


This presentation presents an overview on market liquidity
Agenda

• Introduction
• Market liquidity
– Definition
– Characteristics
– Measurement
– Empirical facts
• Market liquidity risk
– Introduction
– Models
• Summary and open research questions

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Introduction

Liquidity has continuous attention in practice


Press clippings

"Credit crisis puts heat on liquidity Liquidity always a hot topic – especially in
Financial market liquidity can take months to build but just crises
seconds to evaporate [...] Credit traders have received a • Liquidity always scarce when needed most
painful reminder of [...] strangled trading liquidity"
Financial Times, 30.07.2007
Institutional investors engage in illiquid
'Panicked Traders Take VW Shares on a Wild Ride - strategies
stock soared to as high as 1,005 euros a share ... after last • Sometimes large, concentrated position to
week at 210 euros.... short sellers were forced to act"
exploit market inefficiencies
NY Times, 28.08.2008 • Returns due to liquidity risk compensation?
'Some less liquid strategies which also provided genuine
portfolio diversification [...] have romped past the S&P Trading strategies rely on tradability of assets
500' • Hedging often requires frequent trading
Michael Goldman, Global Investor, 04/2007

"Unless you include liquidity in your models, which some Risk management still needs to account for
small funds don't, then the model may not always work." illiquidity
Euromoney, June 2007 • Often neglected
'[Quantitative strategies] rely on their ability to trade with • Strong recent pressure from regulators
high frequency […] What if the model is built to sell a
company at 20, but there is no buyer?'
Euromoney, June 2007

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Market liquidity v090127b.ppt


Introduction

Liquidity is approached from various research directions

Volume / volatilities Market micro-


literature structure
Supply-demand
curve Transaction cost
literature

Liquidity
Anomaly
explanation Limits to
arbitrage
Factor in
asset pricing Risk
Asset
management
management

= Causes

= Effect

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Introduction

This presentation focuses on market liquidity only


Delimitation of topic area

Market liquidity Funding liquidity Monetary liquidity

• Also "asset liquidity" • Liquidity of liabilities • Liquidity of an economy


• Liquidity of assets only • Perspective of a firm
– "Marketability" (solvency)
• Corporate finance view
– "Ease of trading an
asset"
• Perspective of an investor
• Capital market view

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Market liquidity v090127b.ppt


This presentation presents an overview on market liquidity
Agenda

• Introduction
• Market liquidity
– Definition
– Characteristics
– Measurement
– Empirical facts
• Market liquidity risk
– Introduction
– Models
• Summary and open research questions

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Market liquidity v090127b.ppt


Market liquidity – Definition

Liquidity can be defined as the cost of trading an asset


Liquidity cost has three components

Liquidity • Cost L of trading a quantity q of an asset


• Relative to fair value
Lt(q) • Fair value often set at mid-price, i.e. mid-point of bid-ask-spread

=
Direct trading costs • Includes exchange fees, commissions, taxes
• Deterministic
D(q) • Small for institutional investors
+
Price impact costs • Difference between transaction price and mid-price
PIt(q) • Depends on order size q and point of time

+
Delay costs
• Includes search cost, cost due to add. risk during delay
Dt(q)

Note: Definition similar to Amihud (2006), XXX noch ergänzen

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Market liquidity – Definition Backup

The cost perspective integrates older, more elusive definitions

Definition Source Comment


• "Ease of trading an asset" Longstaff • Very general
• "Marketability" (1995) • Cost perspective more
specific

• Tightness = "cost of turning a position Kyle (1985) • Several dimensions


around in a short time" • No unifying perspective
• Depth = "size of an order flow innovation
required to change prices a given amount"
• Resiliency = "speed with which prices
recover from a random, uninformative
shock"

• Immediacy = time between order Black (1971) • A new dimension


submission and settlement • No unifying perspective

• Price Kempf (1999) • Very general


• Time

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Market liquidity – Characteristics

Asset type, order size and horizon are major liquidity determinants

• Liquidity costs decrease with


exogenous

Type of – Trading volume


asset – Value certainty

• Liquidity costs increase with order size


endogenous

Order • Reasons
size • Heterogeneous opinion
• Delay probability
• Capital restrictions

• Liquidity costs decrease with liquidation horizon


endogenous

Liquidation • Costs relative to return are small when held over long period
horizon • Costs are zero for assets held to maturity
• Hence, liquidity is a characteristic of the trading process

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Market liquidity – Characteristics

Liquidity is a continuous characteristic


Liquidity degrees and categories
liquidity costs
Relative

Degree of
illiquidity
liquid illiquid

Costless Costly, continuous Costly, interrupted No


trading trading trading trading
Category

• All order sizes of the • Order sizes can be • Asset are traded from • No order size of the
asset can be traded at traded at a cost time to time asset is traded
zero costs • Price impact cost • Zero trading days occur • Prohibitive Liquidity costs
important • Delay cost important

• Cash • Limit order book markets • OTC markets of more • Rare art, CDOs?
Ex.

of stocks exotic bonds

• None, no liquidity • Precise liquidity cost • Liquidity cost and delay • Intrinsic value
issue
Main

adjustment necessary adjustment adjustment determination because


price non-observable

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Market liquidity – Characteristics

Cost can be measured as price impact curve


Liquidity costs increase with quantity transacted
Price

buy price function

ask price
Bid-ask- mid price
spread area = absolute liquidity costs
bid price

sell price function

Market depth
Quantity
Quote depth / Size of next-best transacted
Size of best limit orders bid order

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Market liquidity – Characteristics

Optimal trading strategies

• Optimal trading strategies can be applied


– Delaying parts of the transaction reduces order size and hence liquidity costs
– But, uncertain future price and liquidity costs, i.e. delay costs, for delayed parts
of the position
– Optimal strategy balances liquidity cost saving against increased delay costs

• Several optimization objectives possible


– Maximize expected liquidation proceeds
– Maximize expected liquidation proceeds with penalty for potential shortfall
(proceed variance)
• Corresponds to maximizing proceeds VaR

• Immediate liquidation as benchmark strategy


– No optimization strategy is applied
– Proceeds are certain

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Market liquidity – Measurement

Measurement of market liquidity is still difficult


Multitude of direct measures and proxies available

• Fees
• Quoted bid-ask-spread (Amihud, Mendelson, JFinEco 86)
• Traded bid-ask-spread
• Effective bid-ask-spread (Roll, JoF 84)
Direct • Relation between price change and order flow (Brennan, Subrahmanyam,
measures JFinEco, 96)
• Price response to turnover (Amihud, JFinMar 02)
• Volume related reversal (Pastor, Stambaugh, JPolEco 03)
• Weighted spread by order size (Irvine et. al., working paper 00)

• Depth
• Volume
Indirect • Number of transactions
measures • Turnover rate (Datar et al, JFinMar 98)(1)
• Proportion of zero-trading days (Bekaert et al., WP, 03)
• Turnover-adjusted zero trading days (Liu, JFinEco 06)

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Market liquidity – Measurement

Example: Weighted spread measures precise size-specific liquidity cost

Weigthed spread is precise measure... ...under realistic assumptions


• Discount vs. achievable price in limit order • Direct trading costs are zero
book – Ok for institutional investors
• Equals area between limit order curves • Asset position continuously tradable
• Ok for developed markets and positions
• Generalization of bid-ask-spread to rest of the
smaller than market depth
limit order book
• Immediate liquidation
• Precise price impact measure
• Ok, if optimal trading strategies
L(q)= WS(q) / 2
neglectable
• Weighted spread data available
• Ok in many electronic limit order book
markets

Source: Stange, Kaserer (2008a, b)

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Market liquidity – Measurement

Liquidity cost quickly rise with order size


Example: Weighted spread for German stocks (I/III)

Average liquidity cost in bp


500
454
SDAX

400

331
TECDAX
300

214
MDAX
200
146
DAX
110
100
52
27
15
0
vol 10 vol 25 vol 50 vol 75 vol 100 vol 150 vol 250 vol 500 vol 750 vol 1000 vol 2000 vol 3000 vol 4000 vol 5000
Volume in k €
Note: Sample = daily data for 160 stocks in four major German stock indices over 5.5 years (II/02-1/08) (not to scale)
Source: Stange, Kaserer (2008a)

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Market liquidity – Measurement

Liquidity cost have strongly declined in 2002-2008


Example: Average weighted spread for German stock indices (II/III)

Source: Stange, Kaserer (2008a)

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Market liquidity – Measurement

Liquidity cost decline evident for all order sizes


Example: Weighted spread for German stocks by selected order size, indexed (II/III)

Source: Stange, Kaserer (2008a)

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Market liquidity – Empirical facts Backup

Further empirical facts

• Liquidity costs can be substantial


– Price impact is concave (Hasbrouck 1991, Stange/Kaserer 2008)
– Over 50% of total trading cost from price impact and delay (Kritzman, Myrgren
and Page 2006)
• There is strong variation over time
– Flight-to-liquidity asymmetry: Liquid assets become more liquid and less liquid
less liquid in crises (Acharya and Pedersen (2005), Longstaff (2004))
• Liquidity measures determine asset prices
– Market liquidity esp. important for pricing – no full diversification possible
(Acharya and Pedersen (2005) for stock market; Goyenko (2005) for
integration between stock and bond market)
– Further sources: Amihud and Mendelson (1986); Datar, Y. Naik, and Radcliffe
(1998); Amihud (2002); Pastor and Stambaugh (2003); Acharya and Pedersen
(2005); Ang, Chen, and Xing (2006), Keene and Peterson (2007) and others
• There is strong liquidity commonality

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Market liquidity v090127b.ppt


This presentation presents an overview on market liquidity
Agenda

• Introduction
• Market liquidity
– Definition
– Characteristics
– Measurement
– Empirical facts
• Market liquidity risk
– Introduction
– Models
• Summary and open research questions

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Market liquidity risk – Introduction

Traditional VaR neglects liquidity effects

Definition classical VaR Critique


• Value-at-Risk (VaR) measures worst loss in • Assumes that position can be liquidated
α% of the cases over a specific forecast without significant cost
horizon h – Bid-ask-spread neglected
– (1-α) is confidence level – Price impact of position size neglected
– Loss is generally the forecasted loss in – Market conditions and liquidation horizon
market prices neglected

• Assumes that position can be liquidated


Future market price distribution at horizon h
within any given horizon
– No delay costs

• Sometimes ad-hoc adjustments from expert


estimates used, but only rough proxy for true
liquidity risk
– Flat lengthening of horizon
– Artificial increase of volatilities
– Flat liquidity cost deduction ("hair cut") by
asset class

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Market liquidity risk – Introduction

Traditional VaR assumes 'mark-to-market'-price by convention


Several price definitions can be used

Before transaction prices After transaction prices

Mid-price = mark-to-market price Transaction price


• Middle of bid-ask-spread • Ex-post achieved transaction price
Bid- / ask-price • Can be inside bid-ask-spread if market
• Usually quoted by market maker maker transacts within spread
– But sometimes best limit order prices • Usually outside bid-ask-spreads for
if no market maker coverage larger order sizes
• Ex-ante achievable transaction price for
buy/sell-transaction
– But for small volume (=bid-ask-
depth) only
Achievable price in limit order book
• Ex-ante price when transacting larger
orders as market order against limit
order book

'Mark-to-market' simple, but not most realistic assumption

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Market liquidity risk – Introduction

Market liquidity risk is worst loss due to liquidity cost

• Liquidity component usually neglected in standard risk models


– Usual assumption that liquidity cost can be neglected if horizon is long enough
– Partially accounted for via asset-class-specific "hair cuts"
• Expert estimates of liquidity cost deduction

• However, liquidity costs are substantial and strongly vary between securities
– 25-30 % underestimation of total risk in emerging market currencies (Bangia et
al. 1999)
– Bid-ask-spread component over 50 % of total risk for illiquid stocks (Le Saout
2002)
– 30 % liquidity contribution to intraday risk in small price stocks (Lai 2007)
– Up to 25-30 % liquidity impact on price risk at 10-day horizons (Stange/Kaserer
2008a)
• More than doubles at daily horizons
• Large variance between stocks and position sizes

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Market liquidity risk – Models

We will survey eight different liquidity risk models


Model overview

Model categories Models


1. Bangia et al. (1999): Add-on model with
• Available data bid-ask-spread
2. Ernst et al. (2008): Modified add-on model
• Type of liquidity measurement with bid-ask-spread
3. Berkowitz (2000): Transaction regression
• Assumptions on the structure of liquidity model
4. Cosandey (2001): Volume based price
impact
5. Angelidis, Benos (2006): Structurally
implied spread
6. Francois-Heude, Wynendaele (2001): Limit
order model
7. Giot, Gramming (2008): T-distributed net
return model with weighted spread
8. Stange, Kaserer (2008): Empirical net-
return model with weighted spread
Note: Untraceable models excluded from overview.

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Market liquidity risk – Models

A simple model deducts worst bid-ask-spread


1 Bangia et al. (1999): Add-on model with bid-ask-spread

Liquidity Measure Advantages and Disadvantages

• Bid-ask-spread • Data available in many markets


• Simple add-on, hence quickly implementable

– Assumes that position can be traded at bid-


ask-spread
• However, liquidity costs can quickly rise
beyond bid-ask-spread when trading
positions larger than bid-ask-depth
• Tends to underestimate risk
Liquidity Risk Measurement – Assumes perfect liquidity – price correlation
• Worst spread and worst price occur
• Worst spread added as cost to worst price
simultaneously
• Tends to overestimate risk
– Logically inconsistent because worst spread
deducted from current, not worst prices
• Easily correctable
• Empirical distribution ( ) used for worst • Tends to overestimate risk
spread estimation – Historical spread distribution might poorly
• Normal distribution used for price risk
proxy for future distribution

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Market liquidity risk – Models

Non-normality of liquidity can be explicitly taken into account


2 Ernst et al. (2008): Modified add-on model with bid-ask-spread (I/II)

Liquidity Measure Advantages and Disadvantages

• Bid-ask-spread • Similar to Bangia et al. (1999), but specifically


• Other liquidity measures can be used accounting for non-normality via Cornish-
analogously Fisher approximation
• Provides empirically more precise results than
Bangia et al. (1999)
• See Ernst et al. (2008)
• Can be applied to other liquidity cost
measures as well
• See Ernst et al. (2009)
Liquidity Risk Measurement
– Skewness and kurtosis need to be
• Worst cost added to worst price
additionally estimated

• Cornish-Fisher approximated percentiles,


which take skewness ( ) and excess-kurtosis
( ) into account

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Market liquidity risk – Models

Modified risk model performs better than Bangia et al. (1999)


2 Ernst et al. (2008): Modified add-on model with bid-ask-spread (II/II)

Note: "Risk correctly estimated" is determined via standard Kupiec (1995)-statistic; Sample = 160 stocks in four major German stock indices over 5.5 years
Source: Ernst, Stange, Kaserer (2008)

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Market liquidity risk – Models

Price impact of order size distilled from transaction data


3 Berkowitz (2000): Transaction regression model

Liquidity Measure Advantages and Disadvantages

• Abs. liquidity cost per share ( ) derived from • Integrates price impact of order size
linear regression of transaction prices when
controlling for other risk factor changes (x) – High data requirements
– Liquidity measure highly approximate
• Measurement very noisy
– Assumption of zero price-liquidity correlation
• Independence between price risk and
liquidity impact

Liquidity Risk Measurement

• Not explicitly defined

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Market liquidity risk – Models

Simple price impact approximation via relative traded shares


4 Cosandey (2001): Price impact derived from volume

Liquidity Measure Advantages and Disadvantages

• Relative increase of traded shares by position • Market volume data available


• Accounts for price impact of order size via
simple theoretical assumption

– No time variation of liquidity (here measured


• Assumes that position increases number of with traded share volume)
shares but total traded value – Price impact linear to relative traded shares
• Concavity of price impact function
neglected
Liquidity Risk Measurement

• Worst price risk adjusted for relative increase


of traded shares

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Market liquidity risk – Models

Liquidity cost derived from theoretical drivers


5 Angelidis, Benos (2006): Structurally-implied spread

Liquidity Measure Advantages and Disadvantages

• Spread model estimated from intraday data • Partially accounts for price impact of order
• Model derived from theoretical ideas on size via increased volume percentile
liquidity drivers
• Traded shares N, degree of info assym. – Unclear if structural model is correct
theta, price elasticity to volume kappa, – Complicated estimation of parameters in
liquidity fixed cost Phi intraday data required
– Possible overestimation because liquidity-
return correlation assumed perfect

Liquidity Risk Measurement

• Structurally-implied spread added to price risk


• Calculated with top-percentile of volume
• Assumes that individual position size
dissipates in market

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Market liquidity risk – Models

Using more limit order book data increases measure preciseness


6 Francois-Heude and Wynendaele (2001): Price impact from best limit orders

Liquidity Measure Advantages and Disadvantages

• Price impact curve estimated from best five • Accounts for price impact of order size
limit orders • Price impact more precise because directly
• Available from Paris Bourse measured in limit order book
• Extrapolated for larger sizes
– Only applicable in electronic limit order book
markets
– Time variation of liquidity neglected
– Assumes perfect correlation between liquidity
and price
Liquidity Risk Measurement – Five best limit orders need to be available
– Intraday only
• Normal price risk adjusted for average price – Liquidity cost only extrapolated for medium to
impact large order sizes
• Correction term for difference between – Somewhat arbitrary spread adjustment
average and stock-specific price impact – Provides empirically imprecise results than
other models using limit order data
• See Ernst et al. (2008)

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Market liquidity risk – Models

Precise price impact measurement with limit order book data


7 Giot, Gramming (2005): T-distributed net-return model with weighted spread

Liquidity Measure Advantages and Disadvantages

• Size-specific liquidity cost extracted as • Accounts for price impact of order size in very
weighted spread from limit order book precise way
• Correctly accounts for liquidity-return
correlation

– Only applicable in electronic limit order book


• at(n) and bt(n) are weighted ask and bid- markets
prices for trading n = q/Pmid shares – Intraday data required if lower frequencies not
provided by exchange
Liquidity Risk Measurement – Possible overestimation if instant liquidation
assumption is suboptimal
• T-distribution percentile of historical net return – Possible distortion through assumption of t-
distribution distributed net-returns
• Net return is mid-price return net of
weighted spread liquidity costs

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Market liquidity risk – Models

Precise empirical price impact measurement with limit order book data
8 Stange and Kaserer (2008): Price impact measured with weighted spread

Liquidity Measure Advantages and Disadvantages

• Size-specific liquidity cost extracted as • Accounts for price impact of order size in very
weighted spread from limit order book precise way
• Correctly accounts for liquidity-return
correlation

– Only applicable in electronic limit order book


• at(n) and bt(n) are weighted ask and bid- markets
prices for trading n = q/Pmid shares – Intraday data required if lower frequencies not
provided by exchange
Liquidity Risk Measurement – Possible overestimation if instant liquidation
assumption is suboptimal
• Empirical percentile of historical net return
distribution
• Net return is mid-price return net of
weighted spread liquidity costs

Source: Stange, Kaserer (2008b)

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Market liquidity risk – Models

Model overview

Source: Stange, Kaserer (2009)

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Market liquidity risk – Models

Limit order data models with superior performance in stocks


Model performance

However, models including delay costs not developed yet


Note: "Acceptance rate" is fraction of stocks where Kupiec (1995)-statistic could not reject deviation between realized and predicted loss frequency; ; Sample
= 160 stocks in four major German stock indices over 5.5 years
Source: Ernst, Stange, Kaserer (2009)

Sebastian Stange and Christoph Kaserer, Chair of Financial Management and Capital Markets 35

Market liquidity v090127b.ppt


This presentation presents an overview on market liquidity
Agenda

• Introduction
• Market liquidity
– Definition
– Characteristics
– Measurement
– Empirical facts
• Market liquidity risk
– Introduction
– Models
• Summary and open research questions

Sebastian Stange and Christoph Kaserer, Chair of Financial Management and Capital Markets 36

Market liquidity v090127b.ppt


Summary Market Liquidity

Market liquidity is cost of trading an asset


• Components: Direct trading costs, price impact costs, delay costs
• Determinants: type of asset, order size, liquidation horizon
• Continuous liquidity degrees – different treatment required
• Optimal trading strategies developed to minimize sum of cost components
– Balance increased delay cost against reduced price impact
– Less relevant for risk management
• Several liquidity measures available
– Direct liquidity measure promise increased precise liquidity measurement

Several models can be chosen to measure market liquidity risk


• Market liquidity risk is substantial, but often neglected
• Models based on limit order data perform better in backtests
• Modified risk model (Ernst et al. 2008) consistently outperforms

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Market liquidity v090127b.ppt


Backup

Interesting open research topics


1. Can the superiority of the model of Ernst et al. (2008) be improved via better moment estimation techniques?**
2. Estimation and validity of optimal trading strategies (OTS)*
– How can parameters of theoretical models with optimal trading strategies be estimated?
– In which situations are optimal trading strategies beneficial compared with instant liquidation - in normal times or also
in crises?
3. In which situations are liquidity costs efficient?
• How should arbitrage strategies be constructed?
• What drives the efficiency of markets?
4. Are total liquidation costs per stock an asset pricing factor?
– Total liquidation costs can be estimated via weighted spread times traded size distribution
5. Can the price impact curve be described via theoretical processes?
– Similar to interest rate curve
– Arbitrage conditions also apply if liquidity price are efficient
– Can be helpful when describing unobservable / hidden liquidity
6. Is it possible to construct liquidity options – in analogy to volatility options?
7. How high are liquidity cost / risk levels between different asset classes?
8. Can the stability of liquidity cost for relative order size be used in liquidity risk measurement?
– Liquidity costs are relatively constant for order size in relation to volume and market value in the cross section
(Stange, Kaserer 2008)
– Is this helpful in implementing an asset class, not asset specific liquidity risk approach?
9. How should liquidity risk be integrated into portfolios?
– What is the role of liquidity commonality in the covariance matrix?

Source: Stange, Kaserer (2009)

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Market liquidity v090127b.ppt


Backup

Further references
• Bervas (2006) "Market Liquidity and its Incorporation Into Risk Management", Banque de France technical
report, http://www.gloriamundi.org
• Ernst, C., S. Stange. and C. Kaserer (2008a) "Accounting for Non-normality in Liquidity Risk", CEFS
working paper 2008 No. 14, www.cefs.de
• Ernst, C., S. Stange. and C. Kaserer (2008b) "Empirical evaluation of market liquidity risk models", CEFS
working paper 2009 No. 1, www.cefs.de
• Erzegovesi (2002) "VaR and Liquidity Risk. Impact on Market Behaviour and Measurement Issues", Alea
Technical Reports Nr. 14, http://eprints.biblio.unitn.it
• Jorion (2007) "Value at risk: the new benchmark for managing Financial risk", 2. Ed., McGraw-Hill, New
York
• Loebnitz (2006) "Market Liquidity Risk: Elusive no more - Defining and quantifying market liquidity risk",
diploma thesis, University of Twente, http://purl.org/utwente/e582
• Mahadevan, A. (2001) "Incorporating Liquidity Risk in VAR estimation", ICICI Working paper,
http://www.gloriamundi.org
• Stange, S. and C. Kaserer (2008a): "The Impact of Order Size on Stock Liquidity - A Representative
Study", CEFS working paper, www.cefs.de
• Stange, S. and C. Kaserer (2008b) "Why and How to Measure Liquidity Risk", CEFS working paper,
www.cefs.de
• Stange, S. and C. Kaserer (2009) "Market Liquidity Risk – An Overview", CEFS working paper,
www.cefs.de

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Thank you for your attention!
Comments are warmly welcome.

Sebastian Prof. Christoph


Stange Kaserer

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Market liquidity v090127b.ppt