Mark to market may be top of the regulatory and industry agenda at the moment, but according to RiskMetrics researcher Carlo Acerbi, mark to liquidity could well be the next big thing in the risk management world. Speaking at Thomson Reuters’ recent Global Pricing Forum in London, Acerbi elaborated on the development of a model to more accurately measure liquidity risk on a given holding.
Acerbi noted that a lot of work in the industry thus far has been focused on concepts such as liquidity premiums and global liquidity indices to determine overall capital market liquidity. However, when it comes down to the level of a portfolio, there is still a lot of work to be done to determine how each component is affected by liquidity risk, and this is where the concept of mark to liquidity comes into play. He believes this framework may be able to help to provide a precise figure for portfolio liquidity risk as a function of the market variables that explain and drive it.
Mark to liquidity is therefore a framework to provide quantitative data on how much a given portfolio is affected by liquidity risk, or how it affects other factors such as value at risk (VaR). In order to explain the theory, Ascerbi elaborated that portfolio liquidity risk, which is at the heart of the model, is the implicit cost faced by a portfolio subject to liquidity or risk constraints in an illiquid market environment. These constraints could be risk or trading limits or margin requirements or other similar limits on a portfolio, all of which add up to what Acerbi calls an overall liquidity policy.
The mark to liquidity framework is based upon the combination of these portfolio constraints and market illiquidity. The calculation therefore quantifies liquidation costs at the level of this liquidity policy in a similar manner to mark to market measures. The strategy behind the framework is not to invent a new liquidity risk measure, according to Acerbi, but to change the definition of portfolio value. In mark to liquidity, he contends that potential liquidation costs due to the commitment to a given liquidity policy (ergo the liquidity structure of the market and the constraints of the portfolio) are taken into account.
“It is no longer a linear function where two values will add up to the sum of their parts, as in VaR calculations. The more granular the portfolio, the less the liquidity risk,” said Acerbi. “These things are not reflected in standard portfolio valuation and this is why the market needs a measure such as mark to liquidity.”
Given the regulatory bent towards forcing firms to more accurately measure their liquidity risk exposure, this model may prove popular as firms seek to roll out new analytics systems in a space that has until now been largely overlooked in terms of the risk function. However, it is early days and feedback is needed on how the models work in practice.