Question

Provide your thoughts and examples on the following.

As a guide a couple of paragraphs or about one side on one-page length for each one.

a. Why is liquidity risk important? What factors go into measuring the risk and do you agree with those.

b. What is one pro and one con to the back-simulation approach in measuring market risk? What can be used to deal with the disadvantage?

Answer 1

a) Liquidity risk is important because it liquidity risk aims at meeting the short term debt obligations of a financial entity without meeting any serious losses.

Market liquidity risk is dependent on following factors :-

1.) Which Exchange - generally stocks on exchanges like NYSE and Shanghai stock exchange have higher liquidity rather than OTC transactions.

2. Time of day - there are specific time of day when liquidity is higher on exchanges.

3. Investment horizon - if the selling horizon is very small liquidity is lower and if more time, liquidity is higher.

Whereas funding liquidity risk can be measured by :-

1. Free cash flow - is the firm able to make enough free cash flow after making expenses to pay its debts.

2. Var - this measure the liquidity of a Financial instrument in the sense of a minimum loss that can happen in case of a certain scenario and with certain probability and time.

3 Varx - Varx is advanced version of var as it measure specifically for crisis period

4 Stimulation - certain stimulations are runed which measures the liquidity keeping other variables constant.

Yes, i agree with these factors.

One pro of using back stimulation approach for market risk -

1. It can be used in millions of scenario rather to generate valuable inputs rather than just 1-2 scenarios.

Disadvantage -

If the data on which stimulation is working is biased, the results of stimulation will also be biased

To deal with the data set to be worked on should be selected carefully and cleaned, it shouldn't have outliers

Please hit like button , took a lot of efforts :)