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Risk measuring under liquidity risk

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  • Erindi Allaj

Abstract

We present a general framework for measuring the liquidity risk. The theoretical framework defines risk measures that incorporate the liquidity risk into the standard risk measures. We consider a one-period risk measurement model. The liquidity risk is defined as the risk that a security or a portfolio of securities cannot be sold or bought without causing changes in prices. The risk measures are decomposed into two terms, one measuring the risk of the future value of a given position in a security or a portfolio of securities and the other the initial cost of this position. Within the framework of coherent risk measures, the risk measures applied to the random part of the future value of a position in a determinate security are increasing monotonic and convex cash sub-additive on long positions. The contrary, in certain situations, holds for the sell positions. By using convex risk measures, we apply our framework to the situation in which large trades are broken into many small ones. Dual representation results are obtained for both positions in securities and portfolios. We give many examples of risk measures and derive for each of them the respective capital requirement. In particular, we discuss the VaR measure.

Suggested Citation

  • Erindi Allaj, 2017. "Risk measuring under liquidity risk," Applied Mathematical Finance, Taylor & Francis Journals, vol. 24(3), pages 246-279, May.
    • Handle: RePEc:taf:apmtfi:v:24:y:2017:i:3:p:246-279
    DOI: 10.1080/1350486X.2017.1374871
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