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10_liquidity_and_model_risk

10_liquidity_and_model_risk - MODEL RISK AND LIQUIDITY RISK...

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MODEL RISK AND LIQUIDITY RISK J. Wei, Department of Management, U of T 1 MGTD78 Definition and dimensions of liquidity Liquidity measures Liquidity-adjusted VaR Liquidity at risk – LaR Liquidity black holes Cases of liquidity risk (MG and LTCM) Nature of models Sources of model risk Managing model risk
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LIQUIDITY J. Wei, Department of Management, U of T 2 MGTD78 So far we focus on market and credit risks; liquidity risk is another important type of risk and it intertwines with all other risks Two types of liquidity risk Trading Risk : easiness to convert assets into cash measured by things like spread and execution time trade-off between market risk and spread (bigger trades will take less time but cause bigger price impact and incur wider spread; smaller trades incur smaller spreads, but takes longer time and faces potential market price movements) Funding Risk : easiness to raise funding as a financial institution (e.g., the ABCP fiasco in Canada – using rolling over CP to finance packaged long-term assets such as car loans and credit card receivables, etc)
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LIQUIDITY: DEFINITION AND DIMENSIONS J. Wei, Department of Management, U of T 3 MGTD78 Definition: The ability to trade large size quickly, at low cost, when you want to trade (Harris, 2003). Dimensions (Harris, 2003): Immediacy (speed, how quickly) Width (cost for a given quantity: bid-ask spread, commission) Depth (quantity at given price) Resilience (speed at which price impact diminishes) Illustration using Nortel stock: 12,000 shares at $2.55 and 8,500 shares at $2.65. You sold 1,200 shares at $2.55, 18 minutes after submitting order. $9.99 flat commission. Immediacy: low, since took so long for a small quantity Width: $9,99 commission per trade; bid-ask spread: $0.10; % bid-ask spread: 0.1/(2.55 + 2.65) = 3.85% Depth: 12,000 at bid and 8,500 at ask (not deep) Resilience: if the price went down after your sell order and it took half a day to recover to the previous level, then less resilient
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LIQUIDITY MEASURES J. Wei, Department of Management, U of T 4 MGTD78 bid-ask spread quoted $ spread: P A – P B quoted % spread: (P A – P B )/P M effective spread ($): 2|P t – P M | effective spread (%): 2|P t – P M |/P t depth: (Q A + Q B )/2 volume (units, daily): V t volume ($, daily): V t P t price impact (ILLIQ): [|P t – P t-1 |/ P t-1 ] / DVOL turnover (daily): volume / shares outstanding others
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LIQUIDITY MEASURES J. Wei, Department of Management, U of T 5 MGTD78 Example: ask: $10.55, 20,000 shares bid: $10.45, 15,000 shares last trade: buy at $10.52, 8,000 shares price before last trade: $10.49 then,
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LIQUIDITY MEASURES J. Wei, Department of Management, U of T 6 MGTD78 We only focus on spread and price impact in this course Why is there a bid-ask spread? Compensate liquidity providers for: order-processing costs (cost of seats, trading cost charged by the exchange, overhead costs, etc) inventory costs (carrying costs, mismatching, price change, etc) asymmetric-information cost (lost to informed traders) Liquidity cost is usually half of the spread times the size of transaction.
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