 Personal Finance PowerPoint Presentation, Liquidity Risk. Prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia Understanding Liquidity Risk, which you can find online. Take a look at the references, resources, continue your research from there. This is by David R. Harper, updated May 31, 2021. In prior presentations, we've taken a look at investment goals, investment strategies. And within that context, we're now looking at understanding liquidity risk. Before the global financial crisis, the GFC liquidity risk was not on everyone's radar. Financial models routinely omitted liquidity risk, but the GFC prompted a renewal to understand liquidity risk. One reason was a consensus that the crisis included a run on the non-depository shadow banking system, providers of short-term financing, notably in the RIPA market, systematically withdrew liquidity. They did this indirectly, but undeniably by increasing collateral haircuts. After the GFC, all major financial institutions and governments are acutely aware of the risk that liquidity withdrawal can be a nasty accomplice to transmitting shocks through the system or even exasperating contagion. So what is liquidity risk? Liquidity is a term used to refer to how easy an asset or security can be bought or sold in the market. So clearly, when we're thinking about liquidity with our own financial portfolio, we're thinking about how easy would it be for us to access those financial assets in the event that we need them in order to pay for, say, bills or something that is coming due. Oftentimes, if we lock things away, if they're less liquid, there might be some more benefit to them. For example, if we put something under the umbrella of a 401k plan or an IRA, now we've made something a little bit less liquid. We can't access it as easily, but we might get a tax benefit from it when we invest in something like a home, for example. That could be a significant asset, but of course it's less liquid. We can't access it as easily to pay the current upcoming bills. So it basically describes how quickly someone can be converted to cash. There are two different types of liquidity risk. The first is funding liquidity or cash flow risk. While the second is market liquidity risk. Also referred to as asset product risk, funding liquidity risk. Funding or cash flow liquidity risk is the chief concern of corporate treasurers who ask whether the firm can fund its liabilities. So same kind of thing goes for the personal kind of cash flow or personal balance sheet and income statement, financial statements. We want to make sure that we have enough liquidity, something on hand to pay the current bills that are coming due. A classic indicator of funding liquidity risk is the current ratio of current assets divided by current liabilities. Current assets being basically the more liquid assets that more easily can be converted into cash. Current liabilities being those things that are going to become due. Typically you got to pay cash generally for them within the next year. So if you look at your current assets divided by your current liabilities, then you're going to get a number hopefully that's over one and that'll give you an indication in terms of how many times over possibly you can pay off your current liabilities with your current cash flow. Now obviously you don't want that number to be too low because you want to be able to pay your bills but you also don't want to have it too high. You don't want to have all your money say in the checking account because that means that you're not putting it somewhere else that could make more money so it's kind of a balancing act. So or for that matter the quick ratio it's another it's a kind of more stringent the quick ratio a more stringent kind of current ratio. So a line of credit would be a classic Medicare. Now obviously if you had a line of credit then that means that if you don't have the cash flow you can always dip into the credit if necessary possibly not wanting to do that. We do that on the personal side of course too but we want to be able to have the access to the cash flow in the event that emergency happens. Market liquidity risk. Market or asset liquidity risk is asset illiquidity. This is the inability to easily exit a position. For example we may own real estate but owing to bad market conditions it can only be sold eminently at a fire sale price. The asset surely has value but if buyers have temporarily evaporated the value cannot be realized. So obviously if we're investing in certain types of asset if the market goes down we're not going to be able to sell those assets at the price we would like to be selling them for. We would like to wait it out hoping that the market goes back up often times. However if we have a lot of our investments in these kinds of assets when the market goes down that may be the precise time that we need more liquidity and that's why we might be trying to tap into selling the assets at that point in time which is a problem because they've gone down in value as well which is why we want to be careful of our liquidity, our diversification with regards to the types of things that we are invested in and possibly have access to more liquidity possibly through an emergency fund and possibly through financing a line of credit or something if we needed to have it. So consider it's virtual opposite a U.S. Treasury bond so a U.S. Treasury bond is usually a really safe kind of place to park the money that's not exactly straight in the checking account so you could get some return on it but it's a more stable area because obviously you have the backing of the U.S. Government to be paying it so that should be hopefully stable. So true a U.S. Treasury bond is considered almost risk-free as you imagine the U.S. Government will default but additionally this bond has extremely low liquidity risk its owner can easily exit the position at the prevailing market price so usually there's not a whole lot of fluctuation with the U.S. Treasury bond and it's a lot easier to exit the position obviously when you exit the position on something like real estate it's going to be a more difficult process and you will be subject to the market with the Treasury bonds it's usually going to be an easier kind of thing to remove yourself if you need the liquidity. So small positions in S&P 500 stocks are similarly liquid so S&P 500 stocks are usually going to be the more stable types of stocks this is an S&P it's like an index fund that's trying to give an average of a certain group of basically stocks usually the more stable type of stocks and if they're not under the umbrella same with the Treasury bonds if they're not under the umbrella of say an IRA or a 401K plan then you can't access them quite as quickly as just getting cash out of the checking account but it's pretty quick pretty easy pretty fast to exit that position so they can be quickly exited at the market price but positions in many other asset classes especially in alternative assets cannot be exited with ease in fact we might even define alternative assets as those with high liquidity risk market liquidity risk can be a function of the following the market microstructure exchanges such as commodity futures are typically deep markets but many over the counter OTC markets are thin asset type simple assets are more liquid than complex assets for example in the crisis CDO is squared CDO to are structured notes collateralized by CDO tranches became especially illiquid due to their complexity so obviously if we put some kind of investment strategy together that is a more complex investment strategy it might be more difficult to remove ourselves from that in the future so substitution if a position can be easily replaced with another instrument the substitution costs are low and the liquidity tends to be higher so if we have certain types of assets that people can substitute other assets for them then it tends to increase the liquidity time horizon if the seller has urgency this tends to exasperate the liquidity risk so obviously if we're in a situation where we need the cash flow then that's going to be that could have a negative impact on the liquidity risk we want to be able to say I'll buy and sell whenever I feel the best time to buy and sell instead of feeling panic because I got to pay a certain thing that's coming due so I need to sell something and I need to sell it now so if a seller is patient then liquidity risk is less of a threat and that comes back to having a diversified portfolio and seeing that we have enough cash flow that will be there especially and even in the event of an emergency possibly by having the emergency fund and or access to credit lines if necessary note the common feature of both types of liquidity risk in a sense they both involve the fact that there's not enough time so clearly when we're looking at liquidity risk we're thinking about how easily how fast we can get access to cash so we're taking a look at basically a time sensitive component or factor illiquidity is generally a problem that can be solved with more time measures of market liquidity risk there are at least three perspectives on market liquidity the most popular and crudest measure is the bid ask spread this is also called with a low or narrow bid ask spread is said to be tight and tends to reflect a more liquid market depth refers to the ability of the market to absorb the sale or exit of a position an individual investor who sales shares of apple for example is not likely to impact the share price on the other hand an institutional investor selling a large block of shares in a small capitalization company will probably cause the price to fall finally resiliency refers to the market's ability to bounce back from temporarily incorrect prices to summarize the bid ask spread measures liquidity in the price dimension and is a feature of the market not the seller or the sellers position financial models that incorporate the bid ask spread adjust for exogenous liquidity and are exogenous liquidity models position size relative to the market is a feature of the seller models that use this major liquidity in the quantity dimension and are generally known as an endogenous liquidity models resiliency measures liquidity in the time dimension and such models are currently rare so at one extreme high market liquidity would be characterized by the owner of a small position relative to a deep market that exists into a tight bid ask spread and highly resilient market so let's break that down just a little bit right so at the one end if you're talking about high market liquidity we would be characterized by an owner of a small position so that would be kind of like us owning the Apple stock because obviously when we sell the Apple stock it's not going to have an impact or decrease the price of the Apple making it easy for us to basically remove ourselves from that position as opposed to if we had a whole lot of Apple stock then it would be more difficult for us to remove ourselves to the position so small position relative to the deep market so a deep market that exists into the tight bid ask spread so we've got the tight spread between the bid and the ask and highly resilient market so the market can come back and is a resilient robust market that we are dealing with so what about volume trading volume is a popular measure of liquidity but is now considered to be a flawed indicator high trading volume does not necessarily imply high liquidity the flash crash of May 6 2010 proved this with painful concrete examples in that case according to the securities and exchange commission the SEC sell algorithms were feeding orders into the system faster than they could be executed volume jumped but many backlog orders were not filled according to the SEC especially in times of significant volatility high trading volume is not necessarily a reliable indicator of market liquidity what's the bottom line liquidity risk can be pursued parsed into funding cash flow or market asset liquidity risk funding liquidity tends to manifest as credit risk or the inability to fund liability produces defaults market liquidity risk manifests as market risk or the inability to sell an asset drives its market price down or worse renders the market price indecipherable market liquidity risk is a problem created by the interaction of the seller and buyers in the marketplace if the seller's position is large relative to the market this is called ingeogenous liquidity risk a feature of the seller if the marketplace has withdrawn buyers this is called exogenous liquidity risk a characteristic of the market which is collection of buyers a typical indicator here is an abnormally wide bid ask price a common way to include market liquidity risk in a financial risk model not necessarily a valuation model is to adjust the penalize the measure by adding subtracting one half the bid ask spread