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After completing this reading, you should be able to:
- Differentiate between sources of liquidity risk, including balance sheet/funding liquidity risk, systematic funding liquidity risk, and transaction liquidity risk, and explain how each of these risks can arise for financial institutions.
- Summarize the asset-liability management process at a fractional reserve bank, including the process of liquidity transformation.
- Describe and hedge funds, particularly in stress situations.
- Compare transactions used in the collateral market and explain risks that can arise through collateral market transactions.
- Describe the relationship between leverage and the return profile of a firm, calculate leverage ratio, and explain leverage effect.
- Explain the effect on a firm’s leverage and the balance sheet of the purchase of long equity positions on margin, entry into short sales, and trading in derivatives.
- Explain methods for measuring and managing funding liquidity risk and transaction liquidity risk.
- Calculate the expected transaction cost and the spread risk factor for a transaction, and calculate the liquidity adjustment to VaR for a position to be liquidated over some trading days.
- Explain interactions between various types of liquidity risk and explain how liquidity risk events can increase systemic risk.
0:00 Introduction
2:46 Sources of Liquidity Risk
5:55 Asset Liability Management (ALM)
9:38 The Asset-Liability Management Process
13:07 Economics of the Collateral Markets
17:01 Types of Collateral Markets
19:24 Leverage Ratio
21:59 The Leverage Effect
24:06 Explicit vs. Implicit Leverage
24:41 Margin Loans and Leverage
27:03 Other Leveraged Positions
32:21 Characteristics of Market Liquidity
33:46 Expected Transactions Cost
37:26 Liquidity-adjusted Value at Risk (LVAR)
44:12 How Hedge Funds Manage Funding Liquidity Risk