Dr.Gang Xu
Department of Economics University of Glasgow gang.xu@gla.ac.uk
August, 2010
Introduction
In this lecture, we will discuss the liquidity risk from the perspectives of nancial institution and regulators. By the end of the lecture, you should understand: The dierence between liquidity and solvency Liquidity trading risk and how to measure liquidity Liquidity funding risk and the main sources of liquidity Liquidity black holes and the reasons why they exist Link the concepts of leveraging, deleveraging and irrational exuberance to the 2007 subprime crisis Required reading: Hull,J. (2009), chapter 19 Recommended reading: Shiller, R. (2005), Irrational Exuberance, 2nd edition, Princeton University Press
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Liquidity trading risk is concerned with the ease with which positions in the trading book can be unwound: Some assets can be converted into cash easily: IBM shares Some assets can not be converted into cash easily: bonds of non-investment-grade company The price at which an asset can be sold depends on: The mid-market price of the asset, or an estimate of its value How much of the asset is to be sold How quickly it is to be sold The economic environment
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Low liquidity is normally evidenced by low trading volume and large bid-ask spreads
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Bid price
Quantity
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The BLOOMBERG PROFESSIONAL service, BLOOMBERG Data and BLOOMBERG Order Management Systems (the Services) are owned and distributed locally by Bloomberg Finance L.P. (BFLP) and its subsidiaries in all jurisdictions other than Argentina, Bermuda, China, India, Japan and Korea (the BLP Countries). BFLP is a wholly-owned subsidiary of Bloomberg L.P. (BLP). BLP provides BFLP with all global marketing and operational support and service for the Services and distributes the Services either directly or through a non-BFLP subsidiary in the BLP Countries. The Services include electronic trading and order-routing services, which are available only to sophisticated institutional investors and only where necessary legal clearances have been obtained. BFLP, BLP and their affiliates do not provide investment advice or guarantee the accuracy of prices or information in the Services. Nothing on the Services shall constitute an offering of financial instruments by BFLP, BLP or their affiliates. BLOOMBERG, BLOOMBERG PROFESSIONAL, BLOOMBERG MARKET, BLOOMBERG NEWS, BLOOMBERG ANYWHERE, BLOOMBERG TRADEBOOK, BLOOMBERG BONDTRADER, BLOOMBERG TELEVISION, BLOOMBERG RADIO, BLOOMBERG PRESS and BLOOMBERG.COM are trademarks and service marks of BFLP, a Delaware limited partnership, or its subsidiaries.
Bloomberg Charts
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Terrorist Attack
Spread
Subprime Crisis
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Lesson learnt from the current crisis : Complex products that are not transparent can be traded in the normal time, but the liquidity for those assets can disappear very soon when things go wrong, because people dont know how to value them
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Liquidity funding risk is concerned with being able to meet cash needs as they arise. how liquidity funding risk and liquidity trading risk are linked? Sources of Liquidity: Liquid Assets Ability to liquidate trading book (the link) Ability to borrow in the wholesale market Ability to attract retail deposit Securitization Central bank borrowing
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Securitization
When banks lend money to borrowers, they create loans which are the certicates entitling them to receive money from the borrowers in the future Instead of keeping loads on the banks own balance sheet, they develop new securities (mortgage backed assets) backed by those loans (securitization) These new securities are issued by the bank to obtain money from investors (sources of liquidity and transfer of risks) During subprime crisis, investors consider those mortgage backed assets too risky because the loans underlying those assets can not be paid in time
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Securitization
Borrower
loans
Financial engineering
money
Question: Does the bank have motivations to check the creditworthiness of the borrower when it originates the loan?
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Borrowing from central bank may destroy the reputation of the bank
A sign that the bank is in serious trouble Northern Rock
Discussion: After the failure of Bear Stern in March 2008, the Federal Reserve Board extended its borrowing facility to investment banks as well as commercial banks, why central banks concerned about the failure of investment banks?
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A liquidity black hole occurs when most market participants want to take one side of the market and liquidity dries up If you want to sell an asset and nd everyone else wants to sell this asset as well You will sell the asset at a lower price, others realize it and will sell it at even lower price The danger in the nancial market is at a time when everyone wants to sell, no buyers. But how could this happen? The crash of 1987
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Liquidity in the market is driven by the behaviour of traders. Negative feedback traders:
Buy when prices fall and sell when prices rise
Discussion Who should dominate the market under normal condition and why? Who can contribute to the creation of liquidity black holes and why Why positive feedback traders exist?
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Financial regulations are a form of regulation or supervision, which subjects nancial institutions to certain requirements, restrictions and guidelines, aiming to maintain the integrity of the nancial system. The nancial regulation body in UK is Financial Service Authority What are the risks for all the nancial institutions to be regulated in the same way? They will react the same to the market movements This has the potential to create liquidity black holes Dierent nancial institutions should be regulated in dierent ways or by dierent regulation bodies
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Leveraging Process:
Investors allowed to increase leverage They buy more assets Asset prices increase Leverage of investors decreases Investors allowed to increase leverage
Deleveraging Process:
Investors required to reduce leverage They sell assets Asset prices decline Leverage of investors increases Investors required to reduce leverage
Discussion: the impacts of leveraging-deleveraging cycle on hedge funds during the current crisis
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Short position: a position assumed when traders sell shares they dont own:
The shares they sell are borrowed from other investors Short position gains when asset price moves down Short selling can reinforce the downside spiral of asset prices, particularly during the crisis period
The Financial Service Authority (FSA) banned short selling during the credit crunch Recently, the German government banned short selling on government bonds
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Investor A 1.Investor A instructs a broker that he (she) wants to short an IBM share (15$)
Investor B
Question: If the IBM share distributes dividends, who should get it, investor A or investor B?
The Market
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The Market 1.Investor A buys the IBM share from the Market (14$) Investor A 2. Investor A returns the share to the broker The Broker 3. The broker returns the share to investor B Investor B
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Convergence Arbitrage
Long illiquid corporate bond The investor then waits for the prices of two bonds converge at the maturity so that the long and short position cancel each other out
Investor
Short liquid government bond Since the prices for the illiquid Bonds are lower, the investor pocket the profits today, which are the difference between the liquid and illiquid bonds
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Long illiquid corporate bond What happened to LTCM is that the bond prices diverged before their convergence, which trigged substantial amount of marginal calls
Investor
Short liquid government bond Since the prices for the illiquid Bonds are lower, the investor pocket the profits today, which are the difference between the liquid and illiquid bonds
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