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Banking Term : Liquidity Risk

Oct 6, 2015 11:42 IST

    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.

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