Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 1. Liquidity Risk

Presented by: Sudhanshu

Module 1. Trading Liquidity Risk

Module 2. Funding Liquidity Risk

Module 3. Liquidity Black Holes and Positive Feedback Training

Module 1. Trading Liquidity Risk

Topic 1. Introduction to Liquidity Risk

Topic 2. Liquidity Trading Risk

Topic 3. Solvency vs. Liquidity

Topic 4. Bid, Offer, and Mid-Market Price

Topic 5. Cost of Liquidation

Topic 1. Introduction to Liquidity Risk

  • What is Liquidity?

    • The ability to trade an asset at its mid-market price and in large quantities quickly.

    • Two main components:

      • Trading Liquidity: The ease of buying or selling an asset without significantly impacting its price.

      • Funding Liquidity: The ability of a firm to meet its financial obligations as they come due.

  • What is Liquidity Risk?

    • The risk that an individual or firm will be unable to meet its short-term financial obligations.

    • It can arise from either an inability to trade assets or an inability to raise cash.

Practice Questions: Q1

Q1. Rigues Bank owns 5 million shares of a stock with a bid price of $10.50 and an offer price of $12.75.
The cost of liquidation in normal market conditions is closest to:
A. $2.813 million.
B. $5.625 million.
C. $6.228 million.

D. $11.250 million.

Practice Questions: Q1 Answer

Explanation: B is correct.

For the stock owned by Rigues, the mid-market value is the middle point between the bid and offer price multiplied by the number of shares: $11.625 × 5million shares = $58,125,000.
The proportional bid-offer spread is equal to the difference between the bid and offer prices divided by the mid-market value: $2.25 / $11.625 = 0.193548. The cost of liquidation is therefore $58,125,000 × (0.193548 / 2) = $5,625,000.

Topic 2. Liquidity Trading Risk

  • Definition: The risk of loss due to the inability to execute a transaction at the prevailing market price.

  • Key Drivers:

    • Market Depth: The volume of orders at each price level. Low depth increases risk.

    • Bid-Ask Spread: The difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. A wider spread indicates higher risk.

    • Execution Time: The time it takes to complete a trade. Longer times increase risk of adverse price movements.

  • Impact: Forced liquidation of assets at unfavorable prices, leading to financial losses.

Topic 3. Solvency vs. Liquidity

  • Solvency:

    • A firm is solvent when its total assets exceed its total liabilities.

    • It's a long-term measure of financial health.

    • A solvent firm can be illiquid.

  • Liquidity:

    • A firm is liquid when it can meet its short-term obligations as they come due.

    • It's a short-term measure of financial health.

    • An illiquid firm can be solvent but may be forced into bankruptcy.

  • The Relationship: A lack of liquidity can eventually lead to a solvency crisis if the firm is forced to sell assets at fire-sale prices.

Topic 4. Bid, Offer, and Mid-Market Price

  • Bid Price: The highest price a buyer is willing to pay for an asset.

  • Offer (Ask) Price: The lowest price a seller is willing to accept for an asset.

  • Bid-Offer Spread: The difference between the offer and bid prices (offer-Bid). It represents the cost of an immediate round-trip transaction.

  • Mid-Market Price: The average of the bid and offer prices.

  • Equation:

 

  • Example: If a stock has a bid price of                                      101, the mid-market price is $$100.50.
\text { Mid }- \text { MarketPrice }=\frac{\text { Bid }+ \text { Offer }}{2}
\text { 100andanofferpriceof }

Topic 5. Cost of Liquidation

  • Definition: The cost incurred when an asset must be sold quickly. This cost is a combination of:

    • The Bid-Ask Spread: You sell at the bid price, not the mid-market price.

    • Price Impact: A large-scale sell order can push the price down as other market participants become aware of the liquidation.

  • Factors Influencing Cost:

    • Asset Type: Illiquid assets (e.g., real estate, private equity) have higher liquidation costs.

    • Market Conditions: Costs are higher in a distressed or volatile market.

    • Trade Size: Larger trades have a more significant price impact and thus a higher cost.

Module 2. Funding Liquidity Risk

Topic 1. Liquidity Funding Risk

Topic 2. Case Studies

Topic 3. Liquidity Risk Ratios

Topic 1. Liquidity Funding Risk

  • Definition: The risk that a firm will be unable to obtain necessary funds to meet its payment obligations.

  • Key Drivers:

    • Creditworthiness: A firm's perceived riskiness can make it difficult or expensive to borrow money.

    • Concentration of Funding: Over-reliance on a single funding source increases risk.

    • Market-wide Conditions: A financial crisis or "flight to quality" can make all funding sources seize up.

  • Impact: A firm may be forced to sell assets, often at a loss, to raise cash.

Topic 2. Case Studies

  • Lehman Brothers (2008):

    • A classic example of both funding and trading liquidity risk.

    • The firm lost market confidence, leading to a freeze in short-term funding markets.

    • This forced the fire-sale of assets, further eroding its capital and leading to bankruptcy.

  • Long-Term Capital Management (LTCM) (1998):

    • A highly leveraged hedge fund that suffered massive losses.

    • The market lacked liquidity to absorb LTCM's unwinding positions, threatening a systemic crisis.

    • This case highlights how a single entity's illiquidity can have a cascading effect on the broader financial system.

Practice Questions: Q1

Q1. Which of the following statements accurately reflects liquidity management for a financial institution?
A. Investments in Treasury securities help a bank increase its risk and return profile.
B. Stability in retail deposits over the years has enhanced bank liquidity.
C. Central bank borrowings are relatively cheap ways for banks to stay afloat.
D. Stressed markets can limit the effectiveness of trading book liquidation strategies.

Practice Questions: Q1 Answer

Explanation: D is correct.

Stressed markets create liquidity challenges, and trading book liquidations that may be effective in normal market conditions may be heavily compromised in stressed market conditions. Treasury investments reduce risk, but that comes with lower expected return. Retail deposits have become less stable, as investors can easily move their funds across banks as they search for higher interest rates. Central bank borrowings are costly, as they come with a high interest rate, a haircut, and a potentially negative signal to the market.

Topic 3. Liquidity Risk Ratios

Current Ratio: Measures a company's ability to pay short-term obligations using current assets.

  • Equation:

​

 

  • Quick Ratio (Acid-Test Ratio): Similar to the current ratio but excludes inventory, as it is often the least liquid current asset.

  • Equation:

​

 

  • Cash Ratio: The most conservative liquidity ratio, measuring a firm's ability to pay off current liabilities with only cash and cash equivalents.

  • Equation:

​

\text { CurrentRatio }=\frac{\text { CurrentAssets }}{\text { CurrentLiabilities }}
\text { QuickRatio }=\frac{\text { CurrentAssets }- \text { Inventory }}{\text { CurrentLiabilities }}
\text { CashRatio }=\frac{\text { Cash }+ \text { CashEquivalents }}{\text { CurrentLiabilities }}

Practice Questions: Q2

Q2. Which of the following factors must be taken into account in the net cash outflows in a 30-day period component of the liquidity coverage ratio (LCR) as required by Basel III?
A. Complete losses on deposits.
B. Partial losses of wholesale funding.
C. Larger haircuts on secured funding.

D. Two notch reductions in credit ratings.

Practice Questions: Q2 Answer

Explanation: C is correct.

Higher haircuts on secured funding is one of the components that needs to be taken into account in the LCR calculation, along with partial losses on deposits, 100% losses on wholesale funding, line of credit drawdowns, and three notch reductions in credit ratings.

Topic 5. Global Regulatory Extensions

  • ECB (2020): Digital Operational Resilience Act (DORA)
    → EU-wide digital risk framework.

  • Singapore (MAS, 2021):
    → WFH operational risk guidance post-pandemic.
    → Emphasis: employee awareness, IT controls, fraud prevention.

Global regulators are aligning ORM with digital transformation and cyber risk realities.

Module 1. Liquidity Black Holes and Positive Feedback Training

Topic 1. Liquidity Black Holes

Topic 2. Positive and Negative Feedback Traders

Topic 3. Leveraging and Deleveraging

Topic 1. Liquidity Black Holes

  •  situation where a market for a particular asset suddenly loses all liquidity.

  • Process:

    • A shock or event causes a minor price drop.

    • Traders with similar positions are forced to sell.

    • This selling pressure drives the price down further.

    • Market makers, seeing the unidirectional flow, withdraw their bids, causing the bid-ask spread to widen dramatically.

    • The market collapses, and a fire-sale cascade ensues, where assets can only be sold at a fraction of their previous value.

Topic 2. Positive and Negative Feedback Traders

  • Positive Feedback Traders:

    • Also known as trend-followers or momentum traders.

    • They buy when prices are rising and sell when prices are falling.

    • Their actions amplify price movements, contributing to bubbles and crashes.

  • Negative Feedback Traders:

    • Also known as contrarians.

    • They sell when prices are rising and buy when prices are falling.

    • They provide a stabilizing force in the market, often acting as a source of liquidity in times of stress.

    • However, they may be overwhelmed by the collective power of positive feedback traders during extreme events.

Topic 3. Leveraging and Deleveraging

  • Leveraging:

    • Using borrowed funds to increase the size of an investment.

    • While it can magnify returns, it also magnifies potential losses.

    • Leveraging increases a firm's need for funding liquidity.

  • Deleveraging:

    • The process of reducing a firm's debt or leverage.

    • This is often done by selling assets to pay down debt.

    • In a crisis, a widespread deleveraging can lead to a "liquidity black hole" as everyone tries to sell at once, pushing prices down and forcing more deleveraging. This is a positive feedback loop.

Practice Questions: Q1

Q1. A highly liquid market tends to result from situations where:
A. stop loss rules take effect as prices decline.
B. negative feedback traders sell shares as prices rise.

C. positive feedback traders purchase shares as prices rise.
D. breakout trading occurs because of prices moving outside of a range.

Practice Questions: Q1 Answer

Explanation: B is correct.

Negative feedback traders who sell shares as prices rise will help to create liquidity and price stability in the market. Stop loss rules as prices decline will only accentuate the decline, reducing liquidity. Positive feedback traders who purchase more shares as prices rise and breakout trading strategies which build on the trend as prices move outside of a range also contribute to illiquidity.