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A generalized theoretical modelling approach for the assessment of economic-capital under asset market liquidity risk constraints

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  • Mazin A.M. Al Janabi

Abstract

This paper proposes a concrete theoretical foundation and a new modelling framework that attempts to tackle the issue of market/liquidity risk and economic-capital estimation at a portfolio level by combining two mutual asset market/liquidity risk models. In essence, this study extends research literature related to the assessment of the asset market/liquidity risk by providing a generalized theoretical modelling underpinning that handle, from the same perspective, market and liquidity risks jointly and integrate both risks into a portfolio setting without a commensurate increase of statistical postulations. As such, we argue that market and liquidity risk components are correlated in most cases and can be integrated into one single market/liquidity framework that consists of two interrelated sub-components. The first component is attributed to the impact of adverse price movements and is modelled based on the concept of liquidity-adjusted value-at-risk framework, while the second component focuses on the risk of variation in transactions costs due to the bid-ask spreads and it attempts to measure the likelihood that it will cost more than expected to liquidate the asset position. As such, the model comprises a new approach to contemplating the impact of time-varying volatility of the bid-ask spread and its upshot on the overall asset market/liquidity risk. The modelling framework can be constructive for financial service industries in emerging-economies and particularly in reinforcing rational economic-capital allocation in light of the aftermaths of the sub-prime financial crisis.

Suggested Citation

  • Mazin A.M. Al Janabi, 2010. "A generalized theoretical modelling approach for the assessment of economic-capital under asset market liquidity risk constraints," The Service Industries Journal, Taylor & Francis Journals, vol. 31(13), pages 2193-2221, April.
    • Handle: RePEc:taf:servic:v:31:y:2010:i:13:p:2193-2221
    DOI: 10.1080/02642069.2010.503878
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    References listed on IDEAS

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    1. Hisata, Yoshifumi & Yamai, Yasuhiro, 2000. "Research toward the Practical Application of Liquidity Risk Evaluation Methods," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 18(2), pages 83-127, December.
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