Adjusting value-at-risk for market liquidity

Liquidity remains a key risk factor in many portfolios, but quantifying it remains an open question. Here, David Cosandey offers a new macroeconomic approach to quantifying liquidity risk based upon trading volume, and incorporates it into VAR, testing his model against empirical data

The Asian and Russian crises of the late 1990s, and the Long-Term Capital Management (LTCM) debacle, demonstrated the need to better understand market liquidity risk. Several methodologies have been suggested that include market liquidity effects in value-at-risk. Some of them rely on bid-ask spreads (Bangia et al, 1999, and Monkkonen, 2000). These approaches raise the difficulty of gathering long time series of bid/ask spreads for different portfolio sizes and securities. Moreover, they are