13. Liquidity Risk Flashcards
Define liquidity risk
The risk of not being able to meet short-term financial demands, without incurring unnecessary costs or unacceptable losses
Define funding liquidity
Ability to settle obligations as they fall due
Define market liquidity
Ability to realize assets at full value and short notice, if necessary
What is the difference between Idiosyncratic and systemic liquidity risk
The first only affects a single firm while the second affects the entire market (ex: 2008 crisis)
Name 3 potential solutions when liquidity is insufficient
- Wholesale funding (loan agreements)
- Sale and repurchase agreement (Repo)
- Securitization (packaging illiquid assets in a bundle and selling it to investors)
Name 3 things that can increase the liquidity risk of a firm.
- Owning assets involving margin or collateral
- Having the credit of the firm downgraded
- Having a liquidity missmatch between assets and liabilities
Name 6 caracteristics of highly liquid assets
- Unencumbered
- Low risk
- Ease and certainty of valuation
- Low correlation with risk assets
- Active and sizeable market
- High quality (from well-capitalized firms)
What is concentration risk?
Concentration risk arises from excessive exposure to a single borrower, counterparty, sector or country.
Name 3 ways to measure concentration risk
- Proportion of total funding liabilities allocated to each counterparty
- Proportion of total funding liabilities by currency
- Proportion of total funding liabilities by term
What is the general principle of liquidity adjusted risk measures?
The general principle of the liquidity adjusted risk measures is that in a crisis bid-ask spreads will be wider, and more unpredictable than in stable markets.
What are 5 subjects that should be covered in an emergency contingency funding plan?
- How to manage liquidity gaps in emergency situations
- The monitoring of liquidity (quantitatively and qualitatively)
- Potential sources of liquidity
- The monitoring of their ongoing access to liquidity
- Assignment of key responsibilities and communication strategies in emergencies
What are key actions to manage liquidity risk? (8)
- Use risk appetite and risk tolerance thresholds
- Use liquidity measures
- Reflect cost of liquidity in pricing
- Use stress scenarios to test the projected income and outgo
- Diversify sources and terms of funding
- Build relationships with funding counterparties
- Maintain an appropriate cushion of liquidities
- Develop, test, and maintain an formal contingency plan
