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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