A Fully Integrated Liquidity Market Risk Model

Attilio Meucci: Going beyond the simple bid—ask spread overlay for a particular value at risk, we introduce a framework that integrates liquidity risk, funding risk, and market risk.


Attilio Meucci

Research Associate, EDHEC-Risk Institute

We overlay a whole distribution of liquidity uncertainty on future market risk scenarios and we allow the liquidity uncertainty to vary from one scenario to another, depending on the liquidation or funding policy implemented. The result is one easy-to-interpret, easy-to-implement formula for the total liquidity-plus-market-risk profit and loss distribution. Using this formula we can stress-test different market risk P&L distributions and different scenario-dependent liquidation policies and funding policies; compute total risk and decompose it into a novel liquidity-plus-market risk formula; and define a liquidity score as a monetary measure of portfolio liquidity. Our approach relies on three pillars: first, the literature on optimal execution, to model liquidity risk as a function of the actual trading involved; second, an analytical conditional convolution, to blend market risk and liquidity/funding risk; third the Fully Flexible Probabilities framework, to model and stress-test market risk even in highly non-normal portfolios with complex derivatives. Our approach can be implemented efficiently with portfolios of thousand of securities. The code for the case study is available at http://www.symmys.com/node/350.

Type: Working paper
Date: le 12/12/2012
Research Cluster : Finance

See Also

Financial Times ranks EDHEC Executive Education among the Top 10 worldwide
- 23-05-2022
EDHEC Business School’s executive education offers rank among the Top 10 globally...
EDHEC partners with VIVATECH 2022 and offers 400 tickets to EDHEC students
- 20-05-2022
EDHEC is once again a partner of the unmissable tech event of the year, Viva Technology...
(Invitation) Inauguration of the Management in Innovative Health Chair - May 30, 2022 in Paris
- 17-05-2022
Emmanuel Métais, Dean of EDHEC Business School and Christophe Durand, General Manager...
- 10-05-2022
Live on YouTube !