Lecture 1: Liquidity Risk

Dr.Gang Xu
Department of Economics University of Glasgow gang.xu@gla.ac.uk

August, 2010

Introduction
In this lecture, we will discuss the liquidity risk from the perspectives of nancial institution and regulators. By the end of the lecture, you should understand: The dierence between liquidity and solvency Liquidity trading risk and how to measure liquidity Liquidity funding risk and the main sources of liquidity Liquidity black holes and the reasons why they exist Link the concepts of leveraging, deleveraging and irrational exuberance to the 2007 subprime crisis Required reading: Hull,J. (2009), chapter 19 Recommended reading: Shiller, R. (2005), Irrational Exuberance, 2nd edition, Princeton University Press
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Liquidity and Solvency

Liquidity refers to the ability of a company to make cash payments as they become due. make full payments in time Solvency refers to a company having more assets than liabilities. If assets are more than liabilities, then equity is positive Asset = Liability + Equity A solvent company may not have enough liquidity: Why? The answer can be found from Northern Rock (1)

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Liquidity Trading Risk

Liquidity trading risk is concerned with the ease with which positions in the trading book can be unwound: Some assets can be converted into cash easily: IBM shares Some assets can not be converted into cash easily: bonds of non-investment-grade company The price at which an asset can be sold depends on: The mid-market price of the asset, or an estimate of its value How much of the asset is to be sold How quickly it is to be sold The economic environment

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Liquidity Trading Risk

Market Maker (Dealer) (2$ profits)

Bid price (14$)

Ask price (16$)

Seller of IBM Shares

Buyer of IBM Shares

Middle Price = 15$

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Liquidity Trading Risk

Mid-market price of the asset is the mid price of the bid and oer (ask) price for an asset. Bid price: the price that a dealer is prepared to pay for an asset Oer (ask) price: the price that a dealer is oering to sell an asset Bid-oer (ask) spread: the amount by which the oer price exceeds the bid price. (Why oer price is higher than bid price?)
The bid-oer spread increases when the size of the trade increases, why? Do the bid-oer spreads in the retail market show the same pattern to those in the wholesale market? If not, why? Do the size of bid-oer spreads tell us anything about the market liquidity?

Low liquidity is normally evidenced by low trading volume and large bid-ask spreads
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Liquidity Trading Risk

Bid and ask prices as a function of quantity transacted

Price Ask price

Bid price

Quantity
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Liquidity Trading Risk

SBRY LN Equity (J Sainsbury PLC) Daily 1/2/2001 - 12/30/2009

The BLOOMBERG PROFESSIONAL service, BLOOMBERG Data and BLOOMBERG Order Management Systems (the Services) are owned and distributed locally by Bloomberg Finance L.P. (BFLP) and its subsidiaries in all jurisdictions other than Argentina, Bermuda, China, India, Japan and Korea

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Liquidity Trading Risk

SBRY LN Equity (J Sainsbury PLC) Daily 1/2/2001 - 12/30/2009

The BLOOMBERG PROFESSIONAL service, BLOOMBERG Data and BLOOMBERG Order Management Systems (the Services) are owned and distributed locally by Bloomberg Finance L.P. (BFLP) and its subsidiaries in all jurisdictions other than Argentina, Bermuda, China, India, Japan and Korea (the BLP Countries). BFLP is a wholly-owned subsidiary of Bloomberg L.P. (BLP). BLP provides BFLP with all global marketing and operational support and service for the Services and distributes the Services either directly or through a non-BFLP subsidiary in the BLP Countries. The Services include electronic trading and order-routing services, which are available only to sophisticated institutional investors and only where necessary legal clearances have been obtained. BFLP, BLP and their affiliates do not provide investment advice or guarantee the accuracy of prices or information in the Services. Nothing on the Services shall constitute an offering of financial instruments by BFLP, BLP or their affiliates. BLOOMBERG, BLOOMBERG PROFESSIONAL, BLOOMBERG MARKET, BLOOMBERG NEWS, BLOOMBERG ANYWHERE, BLOOMBERG TRADEBOOK, BLOOMBERG BONDTRADER, BLOOMBERG TELEVISION, BLOOMBERG RADIO, BLOOMBERG PRESS and BLOOMBERG.COM are trademarks and service marks of BFLP, a Delaware limited partnership, or its subsidiaries.

Bloomberg Charts

1-1

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Liquidity Trading Risk

BidAsk Spread for Sainsbury from 12/07/2000 30/12/2009 8

Dotcom bubble Burst 7

Terrorist Attack

Spread

Subprime Crisis

0 00

01

02

03

04

05 Time

06

07

08

09

10

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Liquidity Trading Risk

Liquidity also depends on the transparency. One perspective to understand the current crisis: Very sophisticated nancial derivatives which depend on the values of subprime mortgages etc are developed Rating agencies give those nance derivatives dierent ratings based on their risk exposures, etc Market participants dont understand how those derivatives are valued, but they trust the rating agency Now what if the rating agencies get things wrong?
Merrill Lynch sold $ 30.6 billion of ABS CDO tranches (AAA rated) to Lone Star Funds for 22 cents in July 2008

Lesson learnt from the current crisis : Complex products that are not transparent can be traded in the normal time, but the liquidity for those assets can disappear very soon when things go wrong, because people dont know how to value them
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Liquidity Funding Risk

Liquidity funding risk is concerned with being able to meet cash needs as they arise. how liquidity funding risk and liquidity trading risk are linked? Sources of Liquidity: Liquid Assets Ability to liquidate trading book (the link) Ability to borrow in the wholesale market Ability to attract retail deposit Securitization Central bank borrowing

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Securitization

When banks lend money to borrowers, they create loans which are the certicates entitling them to receive money from the borrowers in the future Instead of keeping loads on the banks own balance sheet, they develop new securities (mortgage backed assets) backed by those loans (securitization) These new securities are issued by the bank to obtain money from investors (sources of liquidity and transfer of risks) During subprime crisis, investors consider those mortgage backed assets too risky because the loans underlying those assets can not be paid in time

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Securitization

Borrower

loans

money Bank (Creating new securities backed by the loans)

Financial engineering

New securities Investor

money

Question: Does the bank have motivations to check the creditworthiness of the borrower when it originates the loan?
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Central Bank Borrowing

Central banks are referred to as lenders of last resort. Borrowing from central bank needs collateral:
If a commercial bank wants to borrow money from central bank and puts a collaterial worth 10 million, it might get 8 million from the central bank (discount applied) During the subprime crisis, central banks have broadened the range of collaterals accepted in order to add liquidity into the market

Borrowing from central bank may destroy the reputation of the bank
A sign that the bank is in serious trouble Northern Rock

Discussion: After the failure of Bear Stern in March 2008, the Federal Reserve Board extended its borrowing facility to investment banks as well as commercial banks, why central banks concerned about the failure of investment banks?
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Central Bank Borrowing

The dilemma faced by the Bank of England during Northern Rock crisis is that: If Bank of England immediately helps the Northern Rock, it will send the signals to the market that central bank will help with the liquidity management during the crisis, then why would the commercial banks bother with the liquidity management themselves when the central bank will do so If Bank of England doesnt help the Northern Rock, then there will be massive bankruptcies and bank runs which could paralyse the whole economy Key Question: What is the right distribution of responsibility for liquidity management between commercial banks and central banks?

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Liquidity Black Holes

A liquidity black hole occurs when most market participants want to take one side of the market and liquidity dries up If you want to sell an asset and nd everyone else wants to sell this asset as well You will sell the asset at a lower price, others realize it and will sell it at even lower price The danger in the nancial market is at a time when everyone wants to sell, no buyers. But how could this happen? The crash of 1987

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Liquidity Black Holes

Liquidity in the market is driven by the behaviour of traders. Negative feedback traders:
Buy when prices fall and sell when prices rise

Positive feedback traders:

Buy when prices rise and sell when prices fall

Discussion Who should dominate the market under normal condition and why? Who can contribute to the creation of liquidity black holes and why Why positive feedback traders exist?

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Liquidity Black Holes

Financial regulations are a form of regulation or supervision, which subjects nancial institutions to certain requirements, restrictions and guidelines, aiming to maintain the integrity of the nancial system. The nancial regulation body in UK is Financial Service Authority What are the risks for all the nancial institutions to be regulated in the same way? They will react the same to the market movements This has the potential to create liquidity black holes Dierent nancial institutions should be regulated in dierent ways or by dierent regulation bodies

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Liquidity Black Holes

Leveraging: individual and companies increase their borrowings:

Financial Leverage =
Debt Equity

Leveraging Process:
Investors allowed to increase leverage They buy more assets Asset prices increase Leverage of investors decreases Investors allowed to increase leverage

Deleveraging Process:
Investors required to reduce leverage They sell assets Asset prices decline Leverage of investors increases Investors required to reduce leverage

Discussion: the impacts of leveraging-deleveraging cycle on hedge funds during the current crisis

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Liquidity Black Holes

Irrational exuberance was coined by Allan Greenspan in December 1996 Irrational exuberance refers to the traders in dierent nancial institutions become irrationally exuberant about a particular asset class, which results in the dramatic increase of its prices All the traders start selling that assets at the same time when the bubble busts, liquidity black holes Irrational exuberance can explain many nancial crisis:
1987 stock market crash 1994 bond market crash 1997-8 Asian monetary crisis 1998 Long-Term capital Management failure 2007 subprime crisis

Discussion: how traders compensation can exacerbate the irrational exuberance?

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Long Term Capital Management (LTCM)

LTCM is founded by John Meriwether in 1994, its boarders of directors include Myron Scholes and Robert Merton, both of whom won the Nobel Prize in 1997. LTCM recruited the science PhDs from MIT, Harvard etc to construct extremely complicated mathematical pricing and hedging models. Its annualized return of return (after fees) in its rst years reached the level of 40%. However during the 1997 Asian nancial Crisis, LTCM lost 4.6 billion dollars in just 4 months, it was then bailed out by the Federal Reserve and the fund was nally closed in early 2000.
The government bonds are normally considered as risk free assets. However in 1998, Russia defaulted on its government bonds which distorted the whole nancial market.

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Long and Short Position

Long position: a position involving the purchase of an asset:

Long positive gains when asset price moves up

Short position: a position assumed when traders sell shares they dont own:
The shares they sell are borrowed from other investors Short position gains when asset price moves down Short selling can reinforce the downside spiral of asset prices, particularly during the crisis period
The Financial Service Authority (FSA) banned short selling during the credit crunch Recently, the German government banned short selling on government bonds

Question: Shall we totally abandon the short selling?

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Short Selling: Today

Investor A 1.Investor A instructs a broker that he (she) wants to short an IBM share (15$)

4.The broker returns 15$ to the investor A

Investor B

broker 3.The broker sells the share to the market at 15$

2.The broker borrows a share from investor B

Question: If the IBM share distributes dividends, who should get it, investor A or investor B?

The Market

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Short Selling: One Month Later

The Market 1.Investor A buys the IBM share from the Market (14$) Investor A 2. Investor A returns the share to the broker The Broker 3. The broker returns the share to investor B Investor B

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The Collapse of Long Term Capital Management

Long Term Capital Management adopted the trading strategy called convergence arbitrage: Trading philosophy: identify two securities that should have the same theoretical values, if their prices are dierent, then they long the security with low prices and short the security with high price. If they have the same theoretical values, then their prices should eventually be the same Trading Strategies: Long the illiquid bonds (corporate bonds) and short the liquid bonds (government bonds) with the same properties However, Russia defaulted on its treasury bond which results in ight to quality in security market The spread between the liquid bonds and illiquid bonds widened dramatically, LTCM is highly leveraged, so it goes bankrupt because it cant meet the marginal requirements Discussion: do we see the ight to quality under the current subprime crisis?
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Convergence Arbitrage

Long illiquid corporate bond The investor then waits for the prices of two bonds converge at the maturity so that the long and short position cancel each other out

Investor

Short liquid government bond Since the prices for the illiquid Bonds are lower, the investor pocket the profits today, which are the difference between the liquid and illiquid bonds

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Convergence Arbitrage (LTCM)

Long illiquid corporate bond What happened to LTCM is that the bond prices diverged before their convergence, which trigged substantial amount of marginal calls

Investor

Short liquid government bond Since the prices for the illiquid Bonds are lower, the investor pocket the profits today, which are the difference between the liquid and illiquid bonds

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