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Identifying, Measuring, and Monitoring Liquidity Risk
Liquidity risk is the one that happens when some security cannot be liquefied in the market at that instance of time. It cannot be liquefied at the given time in order to stop loss or to make a gain out of that security. The various type of liquidity risks are,
- Asset liquidity happens when the asset cannot be sold in the market due to the unavailability of liquidity in the market. This can be reduced by increasing the time period for bid/offer. Some of the method used to measure asset liquidity risk are,
- Bid offer spread method is a ratio used by investors to identify the price value of the asset.
- Market depth is an amount at which the asset can be sold in the market at various time intervals. They calculate the liquidity cost as the difference of execution price.
- Immediacy is a minimum period required to sell the asset at the desired cost.
- Resilience is a speed at which the asset returns back to its normal value after the sale of the asset in the market.
- Funding liquidity risk happens when the liability cannot be met when they fall due. This can be met only at an uneconomical price (i.e. at a lower price than the market value).It happens when the party who wants to sell the asset cannot find a party who is ready to buy it. When the asset finds no buyer automatically the price of the asset reduces drastically. Some of the method used to measure funding liquidity risk are,
- Liquidity gap method is a difference between the liability and the net asset value of the firm. The firm with negative value must focus on increasing its cash balance. It however does not show how the gap would change with change in firms marginal funding.
- Liquidity risk elasticity is usually used in banks. It is nothing but marginal raise in the value of the banks asset value over the liability when there is a raise in premium on the banks funding cost rises by a small amount.
Some of the method that are used to measure the liquidity risk are,
- What are various types of liquidity risks?
- What are various measures to measure asset liquidity risk?
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