Liquidity Stress Testing in Asset Management -- Part 2. Modeling the Asset Liquidity Risk

TL;DR

This paper develops a comprehensive framework for modeling asset liquidity risk, including a market impact model for transaction costs, to enhance liquidity stress testing in asset management.

Contribution

It introduces a novel market impact model and asset liquidity measures, filling gaps in standardized analytical models for liquidity risk assessment.

Findings

Proposes a two-regime power-law model for price impact.

Defines key asset liquidity measures like liquidity cost and liquidation ratio.

Applies the framework to stocks and bonds, discussing calibration issues.

Abstract

This article is part of a comprehensive research project on liquidity risk in asset management, which can be divided into three dimensions. The first dimension covers liability liquidity risk (or funding liquidity) modeling, the second dimension focuses on asset liquidity risk (or market liquidity) modeling, and the third dimension considers the asset-liability management of the liquidity gap risk (or asset-liability matching). The purpose of this research is to propose a methodological and practical framework in order to perform liquidity stress testing programs, which comply with regulatory guidelines (ESMA, 2019, 2020) and are useful for fund managers. The review of the academic literature and professional research studies shows that there is a lack of standardized and analytical models. The aim of this research project is then to fill the gap with the goal of developing mathematical and statistical approaches, and providing appropriate answers. In this second article focused on asset liquidity risk modeling, we propose a market impact model to estimate transaction costs. After presenting a toy model that helps to understand the main concepts of asset liquidity, we consider a two-regime model, which is based on the power-law property of price impact. Then, we define several asset liquidity measures such as liquidity cost, liquidation ratio and shortfall or time to liquidation in order to assess the different dimensions of asset liquidity. Finally, we apply this asset liquidity framework to stocks and bonds and discuss the issues of calibrating the transaction cost model.