Liquidity And Risk Management
Liquidity and risk management is important in any organization. Organizations need to manage liquidity risks like other risks. Many organizations do not have the right skills to manage liquidity risks. This has made it difficulty for organizations to manage liquidity risks and hence affected liquidity in the organization.
A series of studies have identified various strategies that organizations can use to manage liquidity risks. For instance, the organizations have identified strategies like diversification, VaR etc. The strategies have both negative and positive impact on liquidity. Also, the studies have shown that liquidity and risk management are related as they affect each other differently. This paper analyzes liquidity and risk management.
Discussion
Liquidity refers to the extend at which an asset or security can be sold in the market without influencing the price of the asset. It also refers to the rate at which an asset can be bought in the market without affecting its price .Liquidity is always characterized by increase in trading activity. Liquidity risk refers to a type of risk that an asset cannot be traded easily in the market so as to avoid loss (Walker, 2009).There are various types of liquidity risks. For instance, asset liquidity risks. In this case, organizations find it hard to sell an asset due to lack of enough liquidity in the market.
Organizations can account for asset liquidity risks using various means. For example, they can widen the bid so as to cater for asset liquidity risks. They should also ensure they have enough liquidity reserves so as to overcome asset liquidity risks. Moreover, the organizations can increase the holding period for VaR calculations so as to be able to manage asset liquidity risks. Another risk is funding liquidity risk. This occurs when the liabilities cannot be met if they fall due. It also curs when the liabilities can be fulfilled at an uneconomic price (Walker, 2009).There are various causes of liquidity risks.
For instance, liquidity risks result when a trader who wants to trade an asset is not able to do so because there is no one in the market who wants to trade the asset. This makes it hard for the trade to trade the asset. Liquidity risk is crucial to people who are planning to hold an asset or are holding an asset because it affects their ability to sell or buy the asset (Walker, 2009).A liquidity risk is considered a kind of financial risk as it results due to uncertain liquidity. An organization can loose its liquidity if the credit rating falls. It can also loose its liquidity if it experiences unplanned cash outflows or an event causes other traders to avoid trading with the organization.
In addition, an organization can suffer from liquidity risk if the market it relies on looses liquidity. Liqudity risks contribute a lot to other risks in the organization. For instance, it contributes a lot to credit risks and market risks. A liquidity risk compounds the firms’ market risk if a firm that has illiquid asset is not able to liquidate its position within the time provided (Walker, 2009).
Hence, an organization should manage its liquidity risks so as to be able to manage other risks. Risk management refers to detection, evaluation and prioritizations of various risks. It also involves application of various resources to reduce the risks and utilize the opportunities. Risk management is important in liquidity as it helps manage liquidity risks (Garleanu &Pedersen, 2007).
There are various methods that can be used to manage liquidity risks. First, an organization can use “liquidity adjusted VAR” to manage liquidity risks. A “liquidity adjusted VAR” includes the liquidity risk into “value at risk”. It is always defined as VAR+ELC (“Exogenous liquidity cost”).The ELC is considered the worst expected half spread in a certain confidence level.Additionally, an organization can consider the VAR over a given time that is needed to liquidate the asset. Then calculate the VAR in that time. In this case, the firm is supposed to adjust the holding time in the risk assessment using the length of time that is needed to reviews the company’s position (Garleanu &Pedersen, 2007).Further, the company can use diversification to manage risks.
The company should conduct liquidity providers so as to increase the cost of liquidity. This helps reduce the effect of liquidity. Diversification strategy has been used by many firms to prevent various risks. This is because companies have various liquidity options and this helps reduce the rate of risks associated with liquidity (Garleanu &Pedersen, 2007)..Risk management plays an important role in the allocation of capital for trading. For example, a risk manager can limit the trading desk to a certain value in a day like 89% at risk to $1 million. In this case, the trading desk should choose a point such that it does not drop below the value chosen.
Risk management helps control how organizations use capital while limiting the risks associated with decision. Risk management has various effects on liquidity and the prices of assets in the organization. An organization can benefit a lot from tightening risk management in the organization and controlling its security position. Though this has a lot of advantages, it has some negative effects as it provides more liquidity to other organizations. Using a tight risk management among institutions has an effect on liquidity as it lowers the market liquidity.
This makes it hard for an organization to find any one who has unused risk bearing capacity. This in turn lowers the prices of the liquidity as they are priced (Garleanu &Pedersen, 2007).On the other hand, liquidity affects risk management in various ways and institutions are required to use an adjusted VaR. In this case, the risk assessment should be adjusted to cater for market liquidity by the time required to review the position. For example, if liquidation takes two days more than expected, then one should use a two day VaR than the earlier VaR as it is more effective.
The security risk for two days is greater than the security risk for one day and so, the trader should select a smaller position. This will help him meet his liquidity adjusted value at a risk constraint. This will in turn prevent him from incurring huge looses when he sells his assets. The LVaR will limit the amount of looses incurred by the trader (Al Janabi , 2009).However, subjecting traders in the marketing to LVaR has an impact. First, subjecting traders to LVaR tightens the risk management in the organization and this leads to a more restricted position.
It also lengthens the selling period than it is expected and this increases the risk that is associated with the selling period. This further tightens the risk management in the organization and leads to fall of liquidity prices. The liquidity adjusted risk management increases the search time for sellers and this also increases the risk over the liquidation expected and thus tightening the risk management constraint. This in turn affects the market and makes it hard for organizations to sell their assets (Al Janabi , 2009).
Conclusion
In conclusion, most of the firms are not able to sell or buy their assets because of liquidity risks. Firms have adopted various ways to manage liquidity. For instance, most of the firms use diversification strategy and also LVaR, VaR to manage liquidity risks. The methods have an impact in the organization. Some of the organizations have used tighter risk management. This in turn reduces prices of liquidity. It also leads to increase in the searching period and hence leads to decreased risk bearing capacity.
Reference
Al Janabi ,M.M.(2009).Commodity price risk management: Valuation of large trading portfolios under adverse and illiquid market settings.Journal of Derivatives & Hedge Funds,Vol 15, page 15–50
Garleanu,N.B.,&Pedersen,L.H.(2007).Liquidity and risk management. National bureau of economic research
Walker,G.(2009).Liquidity risk management.Policy conflict and correction. Capital Markets Law Journal,vol 4, issue No.4, page 451-461.
Is this your assignment or some part of it?
We can do it for you! Click to Order!
