Banking Term : Liquidity Risk

When a company or Firm is unable to reach its short term financial demands for preventing loss, then this risk is known as liquidity Risk.

Causes of liquidity Risks: - Such risks arise mainly when

- A Party is looking for trading of an asset, but there is no one who wants to trade for it.

- Liquidity risks also occur due to uncertain liquidity, generally when institution’s credit rating falls.

- A Company may also face such financial risks if market on which it is dependant is subjected to liquidity loss.

- Difficulty in selling of Collateral is also one of the major reasons for liquidity Risks.

Types of liquidity Risks: - There are basically two types of liquidity risk.

a. Funding Liquidity: - This risk includes the following points.

-  Liabilities cannot be met when they fall due.

-  Liabilities can Be only name specific.

-  Can only be met at an uneconomical price.

b. Market Liquidity: - Market liquidity can be calculated by: -

-  Widening Bid

-  Lengthening of holding period for VaR calculations

-  Making explicit liquidity reserves.

Apart from the above measures, there are five derivatives created especially for guarding liquidity risk proposed by Bhaduri, Meissner and Yuan: -

-  Withdrawal option: A part of the illiquid underlying at market price.

-  Return Swap: Swap the underlying’s return for LIBOR paid periodically.

-  Return swaption: Option to enter into the return swap.

-  Liquidity option: “Knock-in” barrier option, where the barrier is a liquidity metric.

-  Bermudan-style return put option: Right to put the option at a specified strike.