Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 1. Liquidity Risk

Presented by: Sudhanshu

Module 1. Trading Liquidity Risk

Module 2. Funding Liquidity Risk

Module 3. Liquidity Black Holes and Positive Feedback Training

Module 1. Trading Liquidity Risk

Topic 1. Liquidity trading risk via cost of liquidation and liquidity-adjusted VaR

Topic 1. Liquidity trading risk via cost of liquidation and liquidity-adjusted VaR

• Liquidity vs. Solvency:

  • Solvency: Assets exceed liabilities (positive equity).

  • Liquidity: The company's ability to meet its obligations as they come due.

• Trading Liquidity: Relates to the ease with which an investment can be unwound (sold).

  • High Liquidity: Large, publicly traded equity securities.

  • Low Liquidity: Non-investment grade debt, emerging market equities.

• Sale Price is a Function of:

  1. Estimated value (mid-market price).

  2. Speed of sale.

  3. Quantity being sold.

  4. Overall economic environment.

• Predatory Trading: Market participants execute similar trades to profit, knowing another entity needs to liquidate a large position, driving the price against the liquidating entity.

• Market Maker Prices:

  • Bid Price: Price at which an asset is sold (lower value).

  • Offer Price: Price at which an asset is purchased (higher value).

• Mid-Market Price: The fair price, halfway between the bid and offer.

• Key Definitions & Formulas:

  • Dollar Bid-Offer Spread ($p$): 

    $$p=\text{Offer price}-\text{Bid price}$$

  • Proportional Bid-Offer Spread ($s$): 

  • Cost to Execute a Single Trade: 

    $$\text{Cost}=s\times (\alpha /2)$$

    where $\alpha$ is the mid-market or dollar value of the position.

• Cost of Liquidation (Normal Market):

  • The total cost to liquidate a book of $n$ investments:

​

• In stressed conditions, the bid-offer spread is not fixed; its uncertainty must be accounted for using mean, standard deviation, and a confidence level (z-score).

• Variables for Stressed Conditions:

  • μi​: Mean proportional bid-offer spread for position $i$.

  • σi​: Standard deviation of the proportional bid-offer spread for position $i$.

  • $\gamma$: Confidence level (z-score for one tail, e.g., 1.645 for 95%).

  • αi​: Mid-market value of position $i$.

• Cost of Liquidation (Stressed Market):

  • This formula assumes a normal distribution for bid-offer spreads and a strong positive correlation between assets during market stress.

​

• LVaR Definition: Estimates Value at Risk (VaR) while explicitly taking the cost of unwinding positions (liquidity risk) into account.

• LVaR (Normal Market): 

  i​​

  (VaR plus the normal market cost of liquidation)

• LVaR (Stressed Market): 

  
  ​

  (VaR plus the stressed market cost of liquidation)

• Trader's Liquidation Decision:

  • Quick Unwind: Reduces risk of mid-market price moving against the trader, but increases risk of widening spread.

  • Slow Unwind: Increases market risk, but decreases risk associated with widening spreads.

  • Trader's Objective (to minimize VaR): 

    
    ​

    (                      
    ​​ represents the market risk, and                  ​ represents the cost of bid-offer spread risk)​

Practice Questions: Q1

Q1. Rigues Bank owns 5 million shares of a stock with a bid price of $10.50 and an offer price of $12.75.
The cost of liquidation in normal market conditions is closest to:
A. $2.813 million.
B. $5.625 million.
C. $6.228 million.

D. $11.250 million.

Practice Questions: Q1 Answer

Module 2. Funding Liquidity Risk

Topic 1. Liquidity Funding Risk

Topic 2. Case Studies

Topic 3. Liquidity Risk Ratios

Topic 1. Liquidity Funding Risk

• Definition: A measure of a firm's ability to meet its cash needs as they come due (i.e., its ability to acquire funding).

• Key Causes of Risk:

  • Weak financial performance.

  • Liquidity stresses resulting in hesitant investors.

  • Funding mismatches (e.g., using short-term instruments to fund long-term requirements).

• Predictability:

  • Some obligations are predictable (e.g., coupon payments).

  • Others are hard to forecast (e.g., customer withdrawals).​

• Six Primary Sources of Liquidity

​

Topic 2. Case Studies

• Northern Rock (2007-2009)

  • Background: British bank heavily involved in mortgage lending, relying on short-term debt for funding.

  • The Crisis: Investors became resistant to lending to banks after the subprime crisis.

  • The Failure: Went to the Bank of England for emergency funding. When the news broke, a massive bank run led to £2 billion in customer withdrawals in a week.

  • Outcome: Emergency borrowing reached £25 billion; the bank was nationalized.

  • Lesson: Mismatched funding (short-term liabilities funding long-term assets) is extremely dangerous under stress.

• ​Ashanti Goldfields (1999)

  • Background: Gold mining company that sold gold forwards (short positions) to hedge against price declines.

  • The Crisis: Central banks limited gold sales, causing gold demand and prices to jump over 25%.

• The Failure: The short positions led to massive margin calls that could not be met in cash.

• Outcome: Forced restructuring, mine sale, and equity dilution.

• Lesson: Illiquidity of underlying assets was misaligned with the immediate need for cash to meet margin calls.

• Metallgesellschaft (MG) (1993)

  • Background: German conglomerate sold long-term (5-10 year) fixed-price supply contracts, hedging with short-term futures contracts (stack-and-roll hedge).

  • The Crisis: Oil prices fell, causing the long futures positions to require large, immediate margin calls (a cash drain).

  • The Failure: Management closed out both the contracts and the hedge, leading to a loss of over $1.3 billion.

  • Lesson: Similar to Ashanti Goldfields, immediate cash outflows (margin calls) were misaligned with the illiquid nature or timing of cash inflows.

Practice Questions: Q1

Q1. Which of the following statements accurately reflects liquidity management for a financial institution?
A. Investments in Treasury securities help a bank increase its risk and return profile.
B. Stability in retail deposits over the years has enhanced bank liquidity.
C. Central bank borrowings are relatively cheap ways for banks to stay afloat.
D. Stressed markets can limit the effectiveness of trading book liquidation strategies.

Practice Questions: Q1 Answer

Explanation: D is correct.

Stressed markets create liquidity challenges, and trading book liquidations that may be effective in normal market conditions may be heavily compromised in stressed market conditions. Treasury investments reduce risk, but that comes with lower expected return. Retail deposits have become less stable, as investors can easily move their funds across banks as they search for higher interest rates. Central bank borrowings are costly, as they come with a high interest rate, a haircut, and a potentially negative signal to the market.

Topic 3. Liquidity Risk Ratios

• Basel III Ratios: Introduced key requirements to ensure banks maintain adequate liquidity buffers.

1. Liquidity Coverage Ratio (LCR)

• Purpose: Ensures the bank has enough High-Quality Liquid Assets (HQLA) to survive a significant 30-day stress scenario.

• Requirement: 

• Stressed 30-Day Period Includes:

  • 100% loss of wholesale funding.

  • Line of credit drawdowns.

  • Partial loss on deposits.

  • Three-notch downgrade of credit ratings.

  • Higher haircuts on secured funding.

2. Net Stable Funding Ratio (NSFR)

• Purpose: Ensures long-term assets are funded with sufficiently stable sources of funding.

• Requirement: 

• Mechanics:

  • Available Stable Funding (ASF): Derived by applying a factor to each funding category (e.g., long-term debt, sticky deposits).

  • Required Stable Funding (RSF): Based on the liquidity characteristics of the bank's assets and off-balance sheet items.

• ​Context: Developed by the Bank for International Settlements (BIS) after the 2007–2009 crisis (17 principles total).

1. Governance & Strategy

• Fundamental Principle: Must have a comprehensive liquidity risk management framework with sufficient unencumbered liquid assets to withstand high stress events.

• Risk Tolerance: Liquidity risk tolerance must be aligned with the bank’s role and business strategy.

• Board Responsibility: The Board must approve strategies, policies, and practices at least annually and ensure effective management by senior staff.

• Pricing & Performance: Liquidity costs, benefits, and risks must be incorporated into internal pricing, performance measurement, and new product approval.​

2. Measurement and Management

• Cash Flow Projections: A sound framework for projecting cash flows is essential for capturing and managing risk.

• Monitoring & Control: Actively monitor and control liquidity risk exposures across business lines, legal entities, and currencies.

• Funding Diversification: Effectively diversify funding sources, maintain strong relationships with providers, and evaluate capacity to raise funds quickly.

• Intraday Liquidity: Manage intraday liquidity positions to meet settlement and payment obligations under normal and stressed conditions.​

3. Stress Testing and Contingency

• Collateral Management: Actively manage collateral, distinguishing between encumbered (pledged) versus unencumbered (free) assets.

• Stress Tests: Conduct regularly to identify strains and adjust strategies; outcomes must align current exposures with risk tolerances.

• Contingency Funding Plan (CFP): A formal plan must be in place to articulate how liquidity shortfalls will be met in emergencies. Must be regularly tested and updated.

• Liquid Assets: Maintain an identified portfolio of High Quality, Unencumbered Liquid Assets readily available without regulatory or legal impediments.

4. Disclosure and Supervision

• Disclosure: Regular, public disclosures allow market participants to assess the bank's liquidity position and the strength of its framework.

• Supervisory Assessment: Supervisors must comprehensively assess the bank's liquidity position and its risk management framework.

• Intervention: Supervisors must be ready to intervene to address deficiencies in a bank's liquidity position or risk processes.

• Communication: Regular communication and increased information sharing between supervisors and public authorities are needed, especially during market stress.

Practice Questions: Q2

Q2. Which of the following factors must be taken into account in the net cash outflows in a 30-day period component of the liquidity coverage ratio (LCR) as required by Basel III?
A. Complete losses on deposits.
B. Partial losses of wholesale funding.
C. Larger haircuts on secured funding.

D. Two notch reductions in credit ratings.

Practice Questions: Q2 Answer

Explanation: C is correct.

Higher haircuts on secured funding is one of the components that needs to be taken into account in the LCR calculation, along with partial losses on deposits, 100% losses on wholesale funding, line of credit drawdowns, and three notch reductions in credit ratings.

Module 3. Liquidity Black Holes and Positive Feedback Training

Topic 1. Liquidity Black Holes and causes of positiv feedback trading

Topic 1. Liquidity Black Holes and causes of positiv feedback trading

• A Liquidity Black Hole (LBH) describes a market condition where liquidity severely or instantaneously evaporates because nearly all market participants want to take the same side of a transaction—typically, everyone wants to sell. It is often referred to as a "crowded exit."

• The Collapse Mechanism:

  • Price declines begin, often due to an external shock, causing investors to panic and attempt to sell to limit losses.

  • As selling accelerates, liquidity quickly disappears because there are no buyers willing to step in.

  • Forced to liquidate, sellers can only offload their assets at prices far below the assets' intrinsic value, amplifying the market crash.

• T​rader behaviour and Market stability: Market stability and liquidity are primarily driven by the collective behavior of traders, who can be categorized as follows:

• Causes of Positive Feedback Trading: When positive feedback traders and strategies dominate, they can create a liquidity black hole. The five main causes are:

A. Trading Strategies and Rules

• ​Stop Loss Rules: These are critical risk management tools, but they trigger sales automatically when an asset's price falls below a predetermined level. If many institutions have similar thresholds, their collective sales actions can instantly overwhelm the buy-side, creating severe selling pressure and accelerating the price decline.

• Trend Trading and Breakout Trading: Strategies that involve buying assets as their prices trend higher and selling them as they trend lower. These systems inherently reinforce the current price movement, driving momentum rather than stabilizing prices.

• Predatory Trading: Traders who learn that a large institution is about to sell a significant position will strategically short the asset before the sale. This action pushes the price down, guaranteeing that the original seller receives a lower price, and allows the predatory trader to profit from the illiquidity they helped create.

B. Derivative Hedging Strategies (Delta Hedging)

• Positive Feedback Effect: The execution of delta hedging for certain short option positions (like short calls or short puts) can reinforce price trends.

  • For example, if an institution is short a call option and the underlying asset price rises, the hedge requires the institution to buy more of the underlying asset. This buying action further increases the price, creating a positive feedback loop.

• Risk: When large institutions hold massive short option positions, their simultaneous hedging trades can pose a serious risk to overall market liquidity.

​C. Leveraging and Margin Calls: Margin Calls as a Stress Multiplier: Investors who use leverage must maintain collateral above a certain minimum level. When leveraged positions move unfavorably, a margin call requires the investor to post additional collateral immediately.

• If the investor cannot meet the cash requirement, they are forced to liquidate (close out) positions. This forced selling accelerates the decline in the asset's price, intensifying the original margin call for other leveraged participants and potentially causing a systemic cascade.

  • Case Example: LTCM (1998) – The highly leveraged Long-Term Capital Management could not meet margin calls after the Russian default. Their forced liquidation of massive bond positions worsened market spreads and required a $3.6 billion bailout to prevent a wider financial collapse.

D. Leveraging and Deleveraging Cycles

• The Leveraging (Upward) Cycle: When liquidity is abundant, banks extend more credit. This increases demand for assets, driving prices up. The rising asset values increase the value of collateral, which facilitates even more borrowing, creating a self-reinforcing, positive feedback loop that leads to market bubbles.

• The Deleveraging (Downward) Cycle: This is the LBH risk. When banks face a liquidity crisis, they tighten lending. Reduced credit leads to falling asset prices, which reduces collateral values. This, in turn, forces banks to reduce their lending even further, creating a downward spiral and a market crash.​

E. Regulatory Uniformity

• The Risk: While regulation is necessary, applying identical rules uniformly across all types of financial institutions (banks, pension funds, life insurance companies) can be destabilizing. If every firm responds to a crisis or market event in the same way (e.g., all selling the same assets simultaneously to meet an LCR threshold), it creates a market consensus that fuels positive feedback.

• The Solution: Regulations should be applied differently to different types of institutions based on their time horizons and risk profiles. This diversity of response is crucial to prevent all trades from being executed identically at the same time, thus reducing the risk of a liquidity black hole.

Practice Questions: Q1

Q1. A highly liquid market tends to result from situations where:
A. stop loss rules take effect as prices decline.
B. negative feedback traders sell shares as prices rise.

C. positive feedback traders purchase shares as prices rise.
D. breakout trading occurs because of prices moving outside of a range.

Practice Questions: Q1 Answer

Explanation: B is correct.

Negative feedback traders who sell shares as prices rise will help to create liquidity and price stability in the market. Stop loss rules as prices decline will only accentuate the decline, reducing liquidity. Positive feedback traders who purchase more shares as prices rise and breakout trading strategies which build on the trend as prices move outside of a range also contribute to illiquidity.