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Lay out and compare ways of measuring and managing two exposures: funding liquidity risk, and the risk of being unable to transact at fair prices.

FRM® Part II · Liquidity and Treasury Risk Measurement and Management · Liquidity and Leverage · FRM2.LTR.2.e

The idea

Funding liquidity risk is measured with cash-flow and maturity ladders under stress, survival horizons and regulatory ratios. A survival horizon is how long counterbalancing capacity covers cumulative net outflows. Counterbalancing capacity means cash plus liquid assets after haircuts. The liquidity coverage ratio is high-quality liquid assets divided by total net cash outflows over 30 stressed days. It must be at least 100%, with inflows counted only up to 75% of outflows. The net stable funding ratio is available stable funding divided by required stable funding, also at least 100%. Management tools are diversified and termed-out funding, collateral buffers, limits and a contingency funding plan. Market liquidity risk is measured with bid-ask spreads, market depth, price impact and days to liquidate. A price impact measure is the Amihud ratio, the average over days of each day's absolute return divided by that day's traded value. Days to liquidate is the position divided by (participation rate × average daily volume). Market liquidity risk is managed with position limits, diversification across liquid assets and staged execution. Read the stress assumptions before computing.

Formulas

Days to liquidate a position

Days = Position ÷ (participation × ADV)

Position
the size of the holding, in shares or value
participation
the share of daily volume the fund allows itself to trade
ADV
average daily volume, in the same unit

Ignoring the participation limit understates the exit time. The longer the exit, the more market risk is borne during liquidation.

Amihud illiquidity ratio

ILLIQ = (1 ÷ N) × Σ (|rₜ| ÷ Vₜ)

N
the number of days
rₜ
the return on day t
Vₜ
the traded value on day t

Average the daily ratios rather than dividing total absolute return by total value, and use absolute returns so up and down days do not cancel. Higher means less liquid.

Liquidity coverage ratio

LCR = HQLA ÷ NCO

HQLA
the stock of high-quality liquid assets
NCO
net cash outflows over a 30-day stress period

At least 100%, with inflows counted only up to 75% of outflows. Read the stress assumptions before computing.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following correctly defines the liquidity coverage ratio (LCR)?

  1. High-quality liquid assets divided by net cash outflows over 30 stressed days, at least 100% - correct
  2. Available stable funding divided by required stable funding over one year, at least 100%Why not: Gives the definition of the net stable funding ratio, not the LCR.
  3. Cash and reserves divided by total assets, with a floor that the central bank sets for each bankWhy not: Describes a simple cash ratio, not the LCR.
  4. Tier 1 capital divided by risk-weighted assets over a one-year horizonWhy not: Describes a capital ratio, not a liquidity measure.

The LCR tests short-term resilience: liquid assets against 30 days of stressed net outflows. The NSFR is the structural one-year measure.

A harder one

A fund holds 2.4 million shares of a stock whose average daily volume is 1.5 million shares. Its liquidity policy allows it to trade at most 20% of daily volume. How many trading days are needed to liquidate the position?

  1. 1.6 daysWhy not: Ignores the participation limit and assumes it can trade the whole average daily volume.
  2. 7.5 daysWhy not: Divides the daily volume by the participation rate and ignores the size of the position.
  3. 8 days - correct
  4. 0.125 daysWhy not: Inverts the calculation, dividing daily tradable volume by the position.

Daily tradable volume = 20% x 1.5 million = 0.3 million shares. Days = 2.4/0.3 = 8. The longer the exit, the greater the market risk borne during liquidation.

The hardest tier

A bank has high-quality liquid assets of USD 180 million, 30-day stressed cash outflows of USD 400 million and stressed inflows of USD 380 million. Inflows are counted up to 75% of outflows. What is its LCR?

  1. 180% - correct
  2. 900%Why not: Counts all inflows of 380 and so ignores the 75% cap on inflows.
  3. 45%Why not: Ignores inflows altogether and divides by gross outflows.
  4. 60%Why not: Caps inflows at 25% of outflows instead of 75%, so net outflows are 300.

Inflows count only up to 0.75 x 400 = 300, so net outflows = 400 - 300 = 100. LCR = 180/100 = 180%. Using all inflows would give net outflows of only 20 and a misleading ratio.

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