Risk Management and Financial Institutions
Risk Management and Financial Institutions Liquidity Risk and Trading Risks Liquidity Risk 1 Types of Liquidity Risk Liquidity trading risk Liquidity funding risk Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 2 2 Liquidity Trading Risk Price received for an asset depends on The mid-market price How much is to be sold How quickly it is to be sold The economic environment As we found in August 2007 transparency is also a factor that affects liquidity Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 3 3 Bid-Offer Spread As a Function of Quantity Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 Offer Price Bid Price Quantity 4 If a seller we focus on the Bid Price If a buyer we are on the Ask Price 4 Measuring Market Liquidity Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 5 Bid-Offer Spread The dollar bid–offer spread () The proportional bid–offer spread () 5 Measuring Market Liquidity Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 6 One measure of the liquidity of a book is how much it would cost to liquidate the book in normal market conditions within a certain time is an estimate of the proportional bid–offer spread in NM conditions for instrument is the dollar value of the position in the instrument and is the number of positions 6 Measuring Market Liquidity Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 7 Cost of liquidation in stressed market conditions Define and as the mean and standard deviation of the proportional bid–offer spread for the financial instrument held The parameter gives the required confidence level for the spread 7 Liquidity-Adjusted VaR Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 8 Although VaR and liquidity risk measures deal with different types of risks, some researchers have suggested combining them into a liquidity-adjusted VaR measure 8 Other Measures of Trading Liquidity Volume of trading per day Price impact of a trade Absolute value of daily return ( divided by daily dollar volume () (see Amihud in 2002) Amihud, Yakov. Illiquidity and stock returns: cross-section and time-series effects. Journal of financial markets 5.1 (2002): 31-56. Amihud shows that an asset’s expected return increases as its liquidity decreases Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 9 Liquidity Funding Risk Sources of liquidity Cash and Treasury securities Ability to liquidate trading positions Ability to borrow Retail and wholesale deposits Securitization Central bank borrowing Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 10 10 Basel III Regulation Liquidity coverage ratio (LCR): designed to make sure that the bank can survive a 30-day period of acute stress LCR implemented in stages between 2015 () and 2019 () Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 11 11 Basel III Regulation Net stable funding ratio (NSFR): a longer term measure designed to ensure that stability of funding sources is consistent with the permanence of the assets that have to be funded Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 12 12 Examples of Liquidity Funding Problems Northern Rock Ashanti Goldfields Metallgesellschaft Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 13 13 Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 Liquidity Black Holes A liquidity black hole occurs when most market participants want to take one side of the market and liquidity dries up Examples: Crash of 1987 British Insurance Companies LTCM (Long-Term Capital Management) 14 Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 LTCM’s Big Loss The hedge fund followed a strategy known as convergence arbitrage (idea: If two securities have the same theoretical price, their market prices should eventually be the same) Find two bonds, X and Y, issued by the same company promising the same payoffs, with X being less liquid (i.e., less actively traded) than Y The market always places a value on liquidity such that Then buy (long) and sell (short) Y 15 Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 LTCM’s Big Loss: Timeline 16 17 Aug., 1998 94-97 1994 Sep. 23, 1998 LTCM is founded Hedge fund’s investment strategy was known as convergence arbitrage Long (short) illiquid (liquid) instruments Annualized return of over 21% (after fees) in its first year, 43% in the second year and 41% in the third year The prices of the bonds LTCM had bought went down and the prices of those it had shorted increased LTCM was highly leveraged. It experienced huge losses and there were margin calls on its positions LTCM’s fund loses 44% of its value ($4 billion) Russia defaults on its government bonds “flight to quality” in capital markets investors valued liquid instruments more highly than usual (spreads between prices of the liquid and illiquid increased) end Aug., 1998 Agreement among 14 Financial institutions for a $3.6 billion bailout under the supervision of the Federal Reserve https://www.youtube.com/watch?v=i-XSi-M1ZkU Positive and Negative Feedback Trading A positive feedback trader buys after a price increase and sells after a price decrease A negative feedback trader buys after a price decrease and sells after a price increase Positive feedback trading can create or accentuate a black hole Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 17 17 Reasons for Positive Feedback Trading Computer models incorporating stop-loss trading Dynamic hedging a short option position LTCM Margin calls Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 18 18 Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 The Impact of Regulation If all financial institution were regulated in the same way, they would tend to react in the same way to market movements This has the potential to create a liquidity black hole 19 The Leveraging Cycle Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 20 Investors allowed to increase to leverage They buy more assets Asset prices increase Leverage of investors decreases When banks are awash with liquidity (e.g., because they have developed ways of securitizing assets or because deposit levels are higher than usual), they make credit easily available to businesses, investors, and consumers 20 The Deleveraging Cycle Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 21 Investors required to reduce leverage They do this is by selling assets Asset prices decline Leverage of investors increases Banks find themselves less liquid for some reason (e.g., because there is less demand for the products of securitization). They become more reluctant to lend money. Credit spreads increase 21 Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 Is Liquidity Improving? Spreads are narrowing But arguably the risks of liquidity black holes are now greater than they used to be It is important to have diversity in financial markets where different groups of investors are acting independently of each other 22 Risk Management and Financial Institutions 5e, Chapter 29, Copyright © John C. Hull 2018 Big Losses Allied Irish Bank ($700 million) Barings ($1 billion) Enron’s Counterparties ($ billions in lawsuits) Hammersmith and Fulham ($600 million) Kidder Peabody ($350 million) LTCM ($4 billion) National Westminster Bank ($130 million) Orange County ($2 billion) Procter and Gamble ($90 million) Soc Gen ($7 billion) Subprime Mortgage Losses ($ tens of billions) UBS (2.3 billion) 23 Risk Management and Financial Institutions 5e, Chapter 29, Copyright © John C. Hull 2018 Risk Limits Risk must be quantified and risk limits set Exceeding risk limits not acceptable even when profits result Do not assume that you can outguess the market Be diversified Scenario analysis and stress testing is important 24 Risk Management and Financial Institutions 5e, Chapter 29, Copyright © John C. Hull 2018 Managing the Trading Room Do not give too much independence to star traders Separate the front middle and back office Do not blindly trust models Be conservative in recognizing inception profits Do not sell clients inappropriate products Beware easy profits 25 Risk Management and Financial Institutions 5e, Chapter 29, Copyright © John C. Hull 2018 Liquidity Risk The credit crisis of 2007 has emphasized the importance of liquidity risk Need to ensure that liquidity funding needs can be met in stressed market conditions Beware when many are following the same strategy Do not make excessive use of short-term borrowings for long-term needs Market transparency is important 26 Risk Management and Financial Institutions 5e, Chapter 29, Copyright © John C. Hull 2018 Lessons for Non-Financial Corporations It is important to fully understand the products you trade Beware of hedgers becoming speculators It can be dangerous to make the Treasurer’s department a profit center 27 A Final Point Three types of risk Known Unknown Unknowable Flexibility is important 28 28 Summary Trading Risks Delta Gamma Rho Theta Vega Liquidity Risk Funding and Trading Liquidity Black holes 29