Question

1. You have been asked to review a memo on how market liquidity is affected by shocks to the financial system. Which of the following observations made in the memo are incorrect. Explain why.
   1. In periods of acute market stress, market liquidity typically increases in the most liquid markets, creating a self-correcting loop that will ultimately remove downward pressure on asset prices
   2. Evaporation of market liquidity is an important factor in determining whether and at what speed financial disturbances become financial shocks with potentially systemic threats
   3. Market shocks may not be reflected in marked-to-market portfolio values immediately for portfolios with illiquid assets. As a result, it is possible for market shocks to have delayed effects on financial institutions
   4. The impact of a market shock on the liquidity of a specific asset depends on the characteristics of the investor who own the asset

Answer 1

All the observations in the memo are correct. Please find below the reason behind it:

1. In periods of acute market stress, market liquidity typically increases in the most liquid markets, creating a self-correcting loop that will ultimately remove downward pressure on asset prices - A liquidity crisis is a financial situation characterized by a lack of cash or easily-convertible-to-cash assets on hand across many businesses or financial institutions simultaneously. In a liquidity crisis, liquidity problems at individual institutions lead to an acute increase in demand and decrease in supply of liquidity, and the resulting lack of available liquidity can lead to widespread defaults and even bankruptcies.

   Maturity mismatching, between assets and liabilities, as well as a resulting lack of properly timed cash flow, are typically at the root of a liquidity crisis. Liquidity problems can occur at a single institution, but a true liquidity crisis usually refers to a simultaneous lack of liquidity across many institutions or an entire financial system.Individual financial institutions are not the only ones who can have a liquidity problem. When many financial institutions experience a simultaneous shortage of liquidity and draw down their self-financed reserves, seek additional short-term debt from credit markets, or try to sell-off assets to generate cash, a liquidity crisis can occur. Interest rates rise, minimum required reserve limits become a binding constraint, and assets fall in value or become unsaleable as everyone tries to sell at once. The acute need for liquidity across institutions becomes a mutually self-reinforcing positive feedback loop that can spread to impact institutions and businesses that were not initially facing any liquidity problem on their own.A negative shock to economic expectations might drive the deposit holders with a bank or banks to make sudden, large withdrawals, if not their entire accounts. This may be due to concerns about the stability of the specific institution or broader economic influences. The account holder may see a need to have cash in hand immediately, perhaps if widespread economic declines are feared. Such activity can leave banks deficient in cash and unable to cover all registered accounts

2. Evaporation of market liquidity is an important factor in determining whether and at what speed financial disturbances become financial shocks with potentially systemic threats -

   Market or asset liquidity risk is asset illiquidity. This is the inability to easily exit a position. For example, we may own real estate but, owing to bad market conditions, it can only be sold imminently at a fire sale price. The asset surely has value, but as buyers have temporarily evaporated, the value cannot be realized.

   Consider its virtual opposite, a U.S. Treasury bond. True, a U.S. Treasury bond is considered almost risk-free as few imagine the U.S. government will default. But additionally, this bond has extremely low liquidity risk. Its owner can easily exit the position at the prevailing market price. Small positions in S&P 500 stocks are similarly liquid. They can be quickly exited at the market price. But positions in many other asset classes, especially in alternative assets, cannot be exited with ease. In fact, we might even define alternative assets as those with high liquidity risk.

3. Market shocks may not be reflected in marked-to-market portfolio values immediately for portfolios with illiquid assets. As a result, it is possible for market shocks to have delayed effects on financial institutions - A Market or Economic economic shock refers to any change to fundamental macroeconomic variables or relationships that has a substantial effect on macroeconomic outcomes and measures of economic performance, such as unemployment, consumption, and inflation. Shocks are often unpredictable and are usually the result of events thought to be beyond the scope of normal economic transactions. Economic shocks have widespread and lasting effects on the economy, and are the root cause of recessions and economic cycles in Real Business Cycle Theory.

   Economic shocks can be classified as primarily impacting the economy through either the supply or demand side. They can also be classified by their origin within or impact upon a specific sector of the economy. Because markets and industries are interconnected in the economy, large shocks to either supply or demand in any sector of the economy can have far-reaching macroeconomic impact. Economic shocks can be positive (helpful) or negative (harmful) to the economy, though for the most part economists, and normal people, are more concerned about negative shocks.

   A financial shock is one that originates from the financial sector of the economy. Because modern economies are so deeply dependent on the flow of liquidity and credit to fund normal operations and payrolls, financial shocks can impact every industry in an economy. A stock market crash, a liquidity crisis in the banking system, unpredictable changes in monetary policy, or the rapid devaluation of a currency would be examples of financial shocks.

4. The impact of a market shock on the liquidity of a specific asset depends on the characteristics of the investor who own the asset - Investors can leverage insights around these imminent events to begin hedging their risks and protecting their portfolio returns, but it’s nearly impossible to predict exactly when the stock market will crash or rally. Rather, the scientific method of scenario analysis is a more effective way to estimate the potential outcomes of hypothetical events, manage expectations, and mitigate risks.