Asset Allocation with Liquidity-Adjusted Market Risk Modeling: Empirical Relevance to Emerging GCC Financial Markets

The aim of this article is to bridge the gap in equity trading risk management literatures and particularly from the perspective of emerging and illiquid markets, such as in the context of the Gulf Cooperation Council (GCC)’s six financial markets. To the authors’ best knowledge, this is the first research paper that addresses the issue of equity trading risk management in the GCC countries with direct applications to their six stock markets. In this paper, the authors demonstrate a practical approach for measurement, management and control of market and liquidity risk exposures for financial trading portfolios that contain several illiquid equity securities. This approach is based on the renowned concept of Liquidity-Adjusted Value at Risk (L-VaR) along with the development of an optimization software tool utilizing matrix-algebra technique under the notion of different correlation factors and liquidation horizons. The comprehensive trading risk model can simultaneously handle L-VaR analysis under normal and severe market conditions besides it takes into account the effects of illiquidity of all traded equity securities. In order to illustrate the proper use of L-VaR and stress-testing methods, real-world examples and feasible reports of equity trading risk management are presented for the six GCC equity financial markets by implementing a daily database of indices’ returns for the period 2004-2008. To this end, several financial modeling studies are achieved with the objective of creating a realistic framework of equity trading risk measurement and control reports in addition to the instigation of a practical iterative optimization technique for the calculation of maximum authorized L-VaR limits subject to real-world optimum operational constraints.