Incorporating Liquidity Risk in VaR Models

First Version: September 2000

This Version: June 2002

LE SAOUT ERWAN♣

Abstract

Conventional Value at Risk models lack a treatment of liquidity risk. Neglecting

liquidity risk leads to an underestimation of overall risk and misapplication of
capital for the safety of financial institutions. Standard Value at Risk model assumes
that any quantity of securities can be traded without influencing market prices. In
reality, most markets are less than perfectly liquid. Recent financial turbulences, as
the collapse of LCTM, prove that liquidity is a significant risk for market players.
The main aim of this article is to demonstrate the importance of the liquidity risk
component in financial markets. First, we make a survey of literature explaining
how the liquidity risk can be incorporated into one single measure of market risk.
Then, we apply the Liquidity Adjusted Value at Risk model provided by Bangia,
Diebold, Schuermann et Stroughair (1999) on the French stock market: our results
indicate that the exogenous liquidity risk defined by Bangia, Diebold, Schuermann
et Stroughair (1999) can represent more than an half of market risk for illiquid
stocks. We extend this model to show that endogenous liquidity risk, which refers to
liquidity fluctuations driven by individual action such as the size of the investors’
position, is also a very important component of overall risk.

Key-words : Liquidity Risk, Value at Risk, Depth, Bid-Ask Spread, Weight

Average Spread.

♣
Paris 1 University - CREFIB & CREREG. Correspondance :erwan.@lesaout.com
This document is available through internet: http://www.market-microstructure.org
I want to thank Professors Patrick Navatte, Patrice Fontaine, Jean-Pierre Gourlaouen, Jacques Hamon, Michel
Levasseur, and Charles-André Vailhen. I also received many helpful comments from participants in presentations at
the 2000 IAE Meeting (Biarritz), the 2001 AFFI Meeting (Namur) and IRG Workshop. All remaining errors are
mine.
 Incorporating Liquidity Risk in Value at Risk Models

Introduction
The Russian financial crisis, which took place in July 1998 and the distribution of the
effects that followed it on all the world financial places, was at the origin of numerous
debates. Many wondered about the components of this systematic crisis. If the
underestimate of credit risks is at the origin of the Russian monetary crisis, one of the
factors prevailing in certainly due to the correlation of the risks. According to the IMF,
the factor, which started this process of interdependance of the risks, is exchange market
illiquidity. In times of crisis, liquidity tends to dry up suddenly; we can observe a
decline of the liquidity’s offer and the increase of assets ’correlation, what has the
consequence of making ineffective the diversification.

This liquidity risk is with difficulty predictable in spite of numerous models including
the value at risk models because it’s very difficult to measure liquidity.

This paper is organised as follows: in a first part, we examine the literature dealing with
the consideration of the liquidity risk in the evaluation of market risk. In a second part,
we adapt the VaR model adjusted by the liquidity proposed by Bangia, Diebold,
Shuermann and Stroughair (1999) on the French stocks market.

1. Liquidity Risk Management

Liquidity becomes a major stake for stock exchange authorities as shown by the
numerous current reorganisation projects. Liquidity is the ability to transact quickly at
low cost a large size position. However, no agreement exits on the proper measurement
of liquidity. Terms such as “large” and “quickly” tend to be subjective. Hence,
following BIS Report (1999), we may define asset liquidity according to at least one of
three dimensions: depth, tightness and resiliency. Tightness, measured by bid-ask
spread, indicates how far transaction price diverges from the mid-price. Depth defines
the maximum number of shares that can be traded without affecting prevailing quoted
market prices. Finally1, resiliency denotes the speed with which price fluctuations
resulting from trades are dissipated or how quickly markets clear order imbalances.

1 Another uses concept is immediacy, which refers to the time between the order placement and its execution. This
dimension incorporates element of tightness, depth and resiliency.

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 Incorporating Liquidity Risk in Value at Risk Models

1.1 Liquidity risk: a definition

Liquidity risk is the risk of loss arising from the cost of liquidating a position. Liquidity
risk increases when markets are not liquid. Typically, market illiquidity manifests itself
in the form of important costs of trade, a weak number of trades and wide bid-ask
spread2. These factors mean that investors who wish to settle a position are going to
have to pay significant costs to do it: they have to bear important cost of trade, relatively
long period of wait because of the absence of counterpart or still sell quickly to an
unfavourable price. It is obvious that most of the market know liquidity troubles. There
are only few markets that can offer an adequate level of liquidity to investors. However,
liquidity of these markets cannot be guaranteed all the trading day or during crisis where
liquidity dries out. So, liquidity risk is an important factor, at least potentially, which is
often ignored by investors.

According to Dowd (1998), it’s possible to distinguish two types of liquidity risk. The
first one is the “normal” liquidity risk which increase according to the exchanges on
markets considered as little liquid. The second type is more insidious. It’s about the
liquidity risk arising during stock market crises where the market loses its current
liquidity level: investors who settles its positions registers so a loss more important than
during normal circumstances.

Consequently, we should modify our conception of the value at risk and take into
account of liquidity. The relation between liquidity costs and the value at risk is
indicated by the figure 1 below. It indicates situation of liquid and illiquid positions. We
can settle our liquid position quickly and to obtain the market price without significant
liquidity cost. On the other hand, we can settle our illiquid position only by paying
conversely proportional costs of liquidation to the period when it was necessary to close
its position: the more the period the investor will have agreed to liquidate his positions
is long, the less the costs will be high. However, it is necessary to be careful in the fact
which during the wait, the price can vary in a very unfavourable way. So, ceteris
paribus, an illiquid asset a most important value at risk if we take into account liquidity
cost.

2
As defined by Dowd (1998).

2
 Incorporating Liquidity Risk in Value at Risk Models

Now we have demonstrated clearly the necessity of taking into account the liquidity
costs in the estimation of value at risk models, we have to know how to do it.

[INSERT FIGURE 1]

1.2 Modelling liquidity risk: a survey

The last few years have witnessed increasing interest in the measurement and
management of liquidity risk. Liquidity risk has been investigated in several ways.
Chordia, Roll and Subrahmanyam (2001), Hasbrouck and Seppi (2001) and Huberman
and Halka (2001) investigate commonalities in liquidity. Authors consider the existence
of a systematic and a specific liquidity risk. Amihud and Mendelson (1986), Brennan
and Subrahmanyam (1996), and Jacoby, Fowler and Gottesman (2000) develop a
CAPM model and examine the relationship between expected return and the liquidity
level. Finally, the last but not the least way, different answers have been proposed to
consider liquidity costs in Value at Risk models.

Prior research investigated the optimal execution strategy for liquidating portfolios.
Jarrow and Subramanian (1997) consider optimal liquidation of an investment portfolio
over a fixed horizon. They derive the optimal execution strategy by determining the
sales schedule that will maximise the expected total sales values. In the same way,
Bertsimas and Lo (1998) derive dynamic optimal trading strategies that minimize the
expected cost of execution over an exogenous time horizon. Then, they obtain an
optimal sequence of trades as a function of market conditions. Almgren and Chriss
(1998) consider the problem of portfolio liquidation with the aim of minimizing a
combination of volatility risk and transaction costs arising from permanent and
temporary market impact. From a simple linear cost model, they build an efficient
frontier in the space of time-dependant probability. They consider the risk-reward trade-
off both from the point of view of classic mean-variance optimization, and the
standpoint of Value at Risk. This analysis leads to general insights into optimal
portfolio trading, and to several applications including a definition of liquidity-adjusted
Value at Risk. Hisata and Yamai (2000) propose a Liquidity Adjusted Value at Risk
model based on the framework presented by Almgren and Chriss (1998). Unlike
Almgren and Chriss (1998), Hisata and Yamai (2000) turn the sales period into an
endogenous variable. This model incorporates the mechanism of the market impact

3
 Incorporating Liquidity Risk in Value at Risk Models

caused by the investor’s own dealings through adjusting Value at Risk according to the
level of market liquidity and the scale of the investor’s position.

According to Lawrence and Robinson (1995), the best way to capture liquidity issues
within the VaR would be to match the VaR time horizon with the time investor believes
it could take to exit the portfolio. For example, if investors believe liquidity is a problem
for the given portfolio, he could estimate the time needed to exit the positions and use
this as his VaR time horizon. As this time horizon is increased (due to the illiquidity of
the portfolio), his reported VaR would also increase to reflect higher risk. Lawrence and
Robinson (1995) appear among the first ones to wonder about the fact that conventional
VaR models often exclude asset liquidity risk. From an example of estimation of Value
at Risk, the authors find that the largest amount of money a position could lose, with a
given degree of confidence, over a one day time horizon is underestimated. Indeed,
according to Lawrence and Robinson (1995), the liquidation of a portfolio during a
trading day generate an additional liquidity cost. The more the time horizon is weak, the
more we underestimate liquidity risk and this, especially the investor’s position is
important. The act to settle a position, in itself, will have a consequence, unfavourable
for the investor, on the price range. So, on the illiquid markets, consequent volume of
assets should bear a high liquidity risk that current Value at Risk models don’t take into
account. From this report, to Lawrence and Robinson (1995) provide a generic model of
Value at Risk by deriving the optimal execution strategy incorporating the market risk
using a mean-standard deviation approach. In the same way, Haberle and Persson
(2000) provide a modelling with easier calculation. The authors propose a method based
on the notion of orderly liquidation3. This method assumes that single investor can
liquidate a fraction of the daily trading volume without significant impact on the market
price.

Le Saout (2000) distinguishes interday and intraday Value at Risk. The author proposes
a new intraday measure of liquidity risk, which is constructed from the return during a
market event defined by a volume movement. His results indicate that we can
distinguish an exogenous liquidity risk, which refers to liquidity fluctuation driven by
factors beyond individual investors’ control, from an endogenous liquidity risk, which

3
The liquidation doesn’t impact the market price.

4
 Incorporating Liquidity Risk in Value at Risk Models

refers to liquidity fluctuations driven by individual actions such as the investors’

position.

Bangia, Diebold, Schuermann and Stroughair (1999) approach the liquidity risk from
another point of view. The summer of 1998 was exceptionally turbulent times for
financial markets. During this period, The authors noticed that losses have been
amplified by the increase of liquidity risk. Bangia, Diebold, Schuermann and Stroughair
(1999) develop a Value at Risk model, which take into account bid-ask spreads. Thus
model allows an increase of the Value at Risk when investors decide to liquidate in the
same time their portfolio. According to Bangia, Diebold, Schuermann and Stroughair
(1999) and Shamroukh (2000), Value at Risk models mustn’t ignore the volatility of the
bid-ask spread even if it is likely to be of at least one order of magnitude than the
volatility of prices. Value at Risk models, which adjust the holding period upward in
line with the inherent liquidity of the position, imply that the liquidation takes place
throughout the holding. Shamroukh (2000) argues that scaling the holding period to
account for orderly liquidation can only be justified if we allow the portfolio to be
liquidated throughout the holding period.

Before any modelling, Bangia, Diebold, Schuermann and Stroughair (1999) study the
nature of the concept that is liquidity. They make the distinction between an
endogenous liquidity and an exogenous liquidity. Exogenous liquidity is the result of
market characteristics; it affects all market players without attribute the responsibility of
the degradation of the liquidity level to one investor rather than another one. This
degradation is the result of a collective action. In contrast, endogenous liquidity is
specific to one’s position in the market. Concretely, the exhibition at the liquidity risk of
an investor is determined by its position: the more the size is important, and the more
the endogenous liquidity risk increases. Figure 2 describes this relationship.

[INSERT FIGURE 2]

Market risk is characterised by the uncertainty of the prices or returns due to market
movements. In a market without friction, risk management deals exclusively with the
distribution of returns. A more rigorous management implies so the consideration of the
“frictions” such as the assets liquidity especially when important positions have to be
liquidated quickly. In this case, investors won’t get the mid-price. Bangia, Diebold,

5
 Incorporating Liquidity Risk in Value at Risk Models

Schuermann and Stroughair (1999) argue that the deviation of this liquidation price
from the mid-price is important components to model in order to capture the overall
risk.

So, the authors estimate the Value at Risk in two stages: uncertainty that increases from
asset returns and uncertainty due to liquidity risk. Figure 3 summarizes their market
taxonomy.

[INSERT FIGURE 3]

2. An empirical analyse on the French Stock Market

In this section, we apply the Liquidity adjusted Value at Risk model provided by
Bangia, Diebold, Schuermann and Stroughair (1999) on the French stock market. First,
we describe briefly the organisation of the French stock market and the database that
were used. Then, we proceed to the estimation of the BDSS’ model. In a third time, we
comment our results. Finally; we extend the modelling of the bid-ask spread to weight
average spread which allows us to show the importance of the endogenous liquidity
component in the Liquidity adjusted Value at Risk model.

2.1. Data

The Paris Bourse is a computerized limit order market in which trading occurs
continuously from 9 a.m. to 5.35 p.m. The trading day takes place in five stages: The
pre-opening phase, the market opening and the continuous market

From 7.45 a.m. to 9.00 a.m., the market is in its pre-opening phase and orders are
accumulated in the centralized order book without any transactions taking place. Each
time an order enters the system, a theoretical equilibrium price is computed.

At 9.00 a.m., the market opens with a batch auction. Depending on the limit orders
received, the central computer automatically calculates the opening price at which the
largest number of bids and asks can be matched.

From 9.00 a.m. to 5.25 p.m., trading takes place on a continuous basis, and the arrival of
a new order immediately triggers one (or several) transaction(s) if a matching order (or
orders) exists on the centralized book. The execution price is the price limit placed on

6
 Incorporating Liquidity Risk in Value at Risk Models

the matching order in the book. Assuming identical price limits, orders are executed as
they arrive: first entered, first matched.

From 5.25 p.m. to 5.30 p.m., the market is in its pre-closing phase and orders are
accumulated in the order book without any transactions taking place.

At 5.30 p.m., the market closes with a batch auction. Depending on the limit orders
received, the central computer automatically calculates the closing price at which the
largest number of bids and asks can be matched.

The database, BDM, we use contains millions data points on transactions: time stamped
stock prices volume, bid/ask spread…We have extracted from the database BDM bid-
ask spread of 41 shares – on the period from October 1st, 1997 to January 3rd, 2000 (that
it represents a little more than 500 consecutive trading days). We opt for a daily data to
estimate Value at Risk in a one day time horizon. This means that we estimate the
maximum loss for a one-day period.

2.2. Modelling Liquidity Adjusted Value at Risk

Following Bangia, Diebold, Schuermann and Stroughair (1999), we estimate the LA-
VaR model by proceeding to a decomposition in two types of risk: the price risk which
correspond to the potential of loss connected to the depreciation of the asset, and the
liquidity risk which corresponds to the liquidity cost supported by the investor who
want to sell his position. This model is described below.

P _ VaR = Pt (1 − e −2 ,33θσ t ) (1)

ECL =
2
[ (
1 α
P S + aσ~t )] (2)

Loss* = Pt (1 − e −2 ,33θσ t ) +
1 α
2
[ (
P S + aσ~t )] (3)

Where: Loss* is the Liquidity Adjusted Value at Risk

ECL is the Exogenous Cost of Liquidation,

Pt is the mid-price at date t ,

7
 Incorporating Liquidity Risk in Value at Risk Models

θ designs a correction factor for current VaR to take account of leptokurtic

return distribution,
σ t is the volatility of the asset at date t ,

Pα is the price Value at Risk at date t ,

S is the average bid-ask spread,

a corresponds to a scaling factor that corrects the bid-ask spread distribution.

σ~t represents the volatility of bid-ask spread.

Estimation of the current VaR

The first stage consists in modelling the conventional Value at Risk from the mid-price.
Generally, the assumption of normality is violated, that’s why Bangia, Diebold,
Schuermann and Stroughair (1999) propose to correct the fat-tails of returns
distributions by incorporating a correction factor θ . This factor is such that θ = 1 if the
security return distribution is normal, and θ > 1 is an increasing function of the tail
causing the deviation from normality. To estimate this correction factor, the author
consider a relationship between the kurtosis K and the factor θ :

K
θ = 1 + φ ⋅ Ln  (4)
3

Where φ is a constant value depends on the tail probability. Following the authors, we
estimated the value of this constant by regressing the right hand side of equation (1)
with historical Value at Risk for the stocks, which composed our sample. So, we have
got a value of 0.039. Then, we are able to estimate the correction factor for our sample.

Figure 4 displays the return distribution and the cumulative frequency of one stock, i.e.
Saint-Gobain chosen for its liquidity and capitalization. We can notice that return
distribution isn’t very far from normality. However, in our sample, as shown in table 1,
some securities such as Clarins and Montupet have a return distribution that doesn’t
look like a Gaussian distribution. Their Kurtosis are over 10. But, generally, return
distributions of the stocks are near the normality distribution.

[INSERT FIGURE 4]

[INSERT TABLE 1]

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 Incorporating Liquidity Risk in Value at Risk Models

Estimation of the Exogenous Cost of Liquidity

The second unknown value that we have to estimate is the scaling factor a that we find
in the equation of Exogenous Cost of Liquidity (Eq. 2). Following Bangia, Diebold,
Schuermann and Stroughair (1999), we have considered two sub-samples: liquid stocks
compose the first one whereas illiquid stocks compose the second sub-sample. Then, we
estimate the scaling factor by regressing the right hand side of the Exogenous Cost of
Liquidity equation with the historical Value at Risk of the bid-ask spread for each sub-
sample. Figure 5 displays the bid-ask spread distribution and the cumulative frequency
of Saint-Gobain. Skewness and kurtosis are relatively high.

[INSERT FIGURE 5]

Hence, we get scaling factors equal to 6.724 for high liquid stock and 7.809 for little
liquidity stock. Effectively, the greater is the deviation from normality, the larger is the
scaling factor.

Estimation of the Liquidity Adjusted Value at Risk

Tables 2 reports the decomposition of market risks (uncertainty in asset returns and due
to liquidity risk) for Saint-Gobain stock.

[INSERT TABLE 2]

Our results can be interpreted as follows: the worst return, given a 99% confidence
level, is estimated like this:

− Gobain = −1,129 * 0,022 * 2,33 = −5,84%

99%
rSaint

So, the Price Value at Risk, at 1% is the following:

−5,84%
− Gobain = 193e = 182,06 euros, so P _ VaR = 10,94 euros.
99%
PSaint

The integration of liquidity risk reduces the price expectation:

ECL =
1
[182.06(0.208% + 6.724 ⋅ 0.041% )] = 0.43
2

Hence, PSa* int −Gobain = 182,06 − 0.43 = 181,63 euros.

Hence, the overall value at risk, given a 99 percent confidence level for a one day time
horizon is:

9
 Incorporating Liquidity Risk in Value at Risk Models

− Gobain = 193 − 181,63 = 11,37 euros (5,89%).

*
LossSaint

The liquidity risk component represent only 3.8% of market risk for Saint-Gobain,
nevertheless table 3 indicates that the percentage can be higher for other stocks. Hence,
concerning the illiquid stock Fromagerie Bel, the liquidity risk represents more than a
half of the market risk.

[INSERT TABLE 3]

To complete this analysis, we have studied the relation between capitalisation and the
Exogenous Cost of Liquidation. Table 4 reports results of the following regression:

ECL = a + b ⋅ Capi (5)

Our results indicate that Exogenous Cost of Liquidation is negatively correlated with
the capitalisation. Lower is the capitalisation of the society, more investors are exposed
to liquidity risk. This result isn’t a surprise but can be considered like an another proof
that small caps funds are aware of liquidity risk.

[INSERT TABLE 4]

2.3. Discussion

The major interest of the model proposed by Bangia, Diebold, Schuermann and
Stroughair (1999) isn’t the estimation of Value at Risk because it is based on historical
simulation, but the decomposition of the market risk in two types: return risk and
liquidity risk.

Nevertheless, the application of this model reveals some limits. The first concerns the
assumption that in adverse market environments extreme event in returns and extreme
events in spreads happen concurrently. The examination of the data showed us that the
widest spreads don’t appear during period of extreme price movements. So, the
Liquidity Adjusted Value at Risk overestimates the overall risk market. The second
limit concern trading volume and position size. The spread indicates the tightness but
not the resiliency. The model deals only exogenous liquidity that implies that overall
risk is underestimated.

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 Incorporating Liquidity Risk in Value at Risk Models

That’s why, to conclude, we have built the same model with the Weight Average
Spread4 for Saint-Gobain stock instead of the bid-ask spread.

Table 4 reports our results. The component liquidity risk has strongly increased: 20.94%
against 3.81%. In the case of Saint-Gobain, the Weight Average Spread is calculated
from 5000 stocks. This means that the endogenous liquidity risk supported by an
investor who hold 5000 stocks is 17.13%.

[INSERT TABLE 5]

Everybody knows the principle of diversification: volatilities of asset risks don’t add
directly. Volatility of portfolio of risks is less than the sum of the individual of the
individual risks’volatilities. One of the consequences of our analyse is that
diversification reduce also endogenous liquidity risk. Financial institutions, which want
to reduce its value at risk, have to diversify its portfolio and so reduce the size of its
positions.

Conclusion
Liquidity risk is an aspect of market risk that has been largely neglected by standard
value at risk model. This negligence is certainly due to the fact that no single measure
captures the various aspect of liquidity in financial markets. In this paper, we apply the
Liquidity Adjusted Value at Risk model provides by Bangia, Diebold, Shuermann and
Stroughair (1999) on the French stock market and extend it incorporating the modelling
of the Weight Average Spread. We demonstrated that liquidity risk, endogenous and
exogenous, can be a very important component of risk market. This means that
nowadays, the risk is underestimated. These results are not without consequences on the
safety of financial institutions.

4
See Appendix for a definition of Weight Average Spread at Paris Bourse.

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 Incorporating Liquidity Risk in Value at Risk Models

Figures and Tables

FIGURE 1
Value at Risk and holding period
VaR

VaR ( Illiquid Position )

VaR ( Liquid Position )

Holding Period
Source : Dowd (1998)

FIGURE 2
Effect of position size on liquidation value
Price Point of endogenous
illiquidity
Ask

Bid

Quote depth Position size

Source : Bangia, Diebold, Schuermann and Stroughair (1999).

12
 Incorporating Liquidity Risk in Value at Risk Models

FIGURE 3
Taxonomy of market risk
Uncertainty in
Market Value

Uncertainty in Uncertainty due to

Asset Returns Liquidity Risk

Exogenous Endogenous
Illiquidity Illiquidity

Source : Bangia, Diebold, Schuermann and Stroughair (1999).

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 Incorporating Liquidity Risk in Value at Risk Models

FIGURE 4
Return Distribution and Cumulative Frequency
12% 6%

10% 5%

8% 4%

6% 3%

4% 2%

1%
2%
0%
0% -7,0% -6,5% -6,0% -5,5% -5,0% -4,5% -4,0% -3,5%
-7% -6% -4% -3% -1% 1% 2% 4% 5% 7%

normal Saint-Gobain normal Saint-Gobain

FIGURE 5
Bid-Ask spread Distribution and Cumulative Frequency
35% 60%

30% 50%
25%
40%
20%
30%
15%
20%
10%
10%
5%

0% 0%
0,10% 0,15% 0,20% 0,25% 0,30% 0,35% 0,35% 0,33% 0,30% 0,28% 0,25% 0,23% 0,20%

normal Saint-Gobain normal Saint-Gobain

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 Incorporating Liquidity Risk in Value at Risk Models

TABLE 1
Estimation of Price Value at Risk

Name Price Kurtosis Volatility Correction VaR 99%

(euros) factor (euros)
ACCOR 48 6,088 0,024 1,241 44,77
AIR LIQUIDE 169 3,427 0,021 1,045 160,51
ALCATEL 227,7 4,728 0,033 1,155 208,43
ATOS 172,8 7,804 0,029 1,325 157,83
BIC 44,01 4,036 0,025 1,101 41,30
BNP 92,5 4,928 0,028 1,169 85,60
BONGRAIN 331,4 5,864 0,020 1,228 313,33
BOUYGUES 636 7,667 0,026 1,319 587,15
CANAL + 135 7,571 0,026 1,315 124,80
CAP GEMINI 255,9 6,764 0,032 1,276 232,82
CARREFOUR 183,5 4,848 0,022 1,163 173,09
CASINO 115,1 6,428 0,019 1,259 108,85
CLARINS 118 11,628 0,023 1,461 109,10
CLUB MED 114,1 10,769 0,022 1,435 105,98
DYNACTION 28 5,334 0,021 1,196 26,44
ELF 149,1 7,176 0,026 1,297 137,89
FROM. BEL 700 5,305 0,016 1,194 669,05
INFOGRAMES. 35 4,685 0,025 1,152 32,76
LABINAL 110 4,106 0,026 1,107 102,80
LAFARGE 115,5 3,282 0,024 1,031 109,11
L'OREAL 789 4,448 0,024 1,134 740,04
LVMH 444 3,896 0,024 1,089 418,01
MICHELIN 39,79 4,688 0,025 1,152 37,16
MONTUPET 33 13,168 0,029 1,503 29,77
MOULINEX 10,1 5,090 0,026 1,180 9,40
PARIBAS 110,4 8,890 0,024 1,369 102,32
PENAUILLE 400 5,730 0,022 1,220 376,04
REXEL 88,45 4,399 0,024 1,130 83,11
SAINT-GOBAIN 193 4,388 0,022 1,129 182,06
SEB 74,8 6,177 0,026 1,246 69,27
SEITA 42,2 4,965 0,023 1,171 39,66
SKIS ROSS. 16 6,682 0,020 1,272 15,07
SODEXHO 168 3,777 0,023 1,078 158,58
SPIR COM. 77,5 10,968 0,024 1,441 71,46
SUEZ 159,9 4,446 0,018 1,134 152,56
TECHNIP 104,6 4,377 0,026 1,128 97,78
TOTAL 132 4,624 0,023 1,147 124,05
USINOR 18,92 6,094 0,026 1,241 17,55
VALEO 76,2 3,453 0,025 1,048 71,69
VIVENDI 87,2 3,793 0,018 1,080 83,32
ZODIAC 208 5,726 0,023 1,220 194,94

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 Incorporating Liquidity Risk in Value at Risk Models

TABLE 2
Liquidity Risk Summarised of Saint-Gobain stock

Saint-Gobain
Price on January, 3rd (euros) 193
Return volatility 0,022
Correction factor 1,129
Price component 10.94
Average bid-ask spread 0,208%
Bid-ask spread volatility 0,041%
Liquidity component 0.43
Liquidity Adjusted Value at Risk (euros) 11.37
% Liquidity Component 3.81%

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 Incorporating Liquidity Risk in Value at Risk Models

TABLE 3
Estimation of Liquidity Adjusted Value at Risk
Summary

Name Price VaR Average LAVaR %

(euros) 99% spread 99% Liquidity
ACCOR 48 44,77 0,259% 44,59 5,05%
AIR LIQUIDE 169 160,51 0,215% 160,14 4,16%
ALCATEL 227,7 208,43 0,172% 208,02 2,11%
ATOS 172,8 157,83 0,502% 156,49 8,19%
BIC 44,01 41,30 0,417% 40,97 10,82%
BNP 92,5 85,60 0,189% 85,32 3,93%
BONGRAIN 331,4 313,33 0,811% 306,17 28,39%
BOUYGUES 636 587,15 0,369% 582,88 8,04%
CANAL + 135 124,80 0,315% 124,22 5,38%
CAP GEMINI 255,9 232,82 0,307% 231,36 5,94%
CARREFOUR 183,5 173,09 0,151% 172,80 2,71%
CASINO 115,1 108,85 0,264% 108,42 6,47%
CLARINS 118 109,10 0,514% 108,06 10,51%
CLUB MED 114,1 105,98 0,633% 104,51 15,28%
DYNACTION 28 26,44 0,886% 25,97 23,08%
ELF 149,1 137,89 0,231% 137,34 4,65%
FROM. BEL 700 669,05 1,376% 635,26 52,20%
INFOGRAMES 35 32,76 0,640% 32,32 16,54%
LABINAL 110 102,80 0,739% 101,17 18,51%
LAFARGE 115,5 109,11 0,241% 108,74 5,60%
L'OREAL 789 740,04 0,197% 738,34 3,35%
LVMH 444 418,01 0,197% 416,98 3,80%
MICHELIN 39,79 37,16 0,230% 37,03 4,75%
MONTUPET 33 29,77 0,971% 28,77 23,60%
MOULINEX 10,1 9,40 0,661% 9,26 17,21%
PARIBAS 110,4 102,32 0,243% 101,82 5,76%
PENAUILLE 400 376,04 1,434% 363,16 34,96%
REXEL 88,45 83,11 0,777% 81,76 20,26%
SEB 74,8 69,27 0,693% 68,37 13,91%
SEITA 42,2 39,66 0,646% 39,06 19,20%
SKIS ROSS. 16 15,07 0,904% 14,76 25,44%
SODEXHO 168 158,58 0,436% 157,08 13,71%
SPIR COM. 77,5 71,46 0,862% 69,69 22,70%
SUEZ 159,9 152,56 0,159% 152,18 4,81%
TECHNIP 104,6 97,78 0,653% 96,57 15,12%
TOTAL 132 124,05 0,187% 123,76 3,61%
USINOR 18,92 17,55 0,320% 17,47 5,52%
VALEO 76,2 71,69 0,387% 71,03 12,84%
VIVENDI 87,2 83,32 0,162% 83,10 5,48%
ZODIAC 208 194,94 0,573% 192,51 15,65%

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 Incorporating Liquidity Risk in Value at Risk Models

TABLE 4
Regression between the Exogenous Cost of Liquidation and the capitalisation
ECL = a + b ⋅ Capi
Coefficients Standard Error t-student
Constant 0,014 0,002 8,826
Capitalisation -4,93E-10 1,15E-10 -4,279
R²=0,319 F=18,312

TABLE 5
Liquidity Risk Summarised of Saint-Gobain stock
Weight Average Spread

Saint-Gobain
Price on January, 3rd (euros) 193
Return volatility 0.022
Correction factor 1.129
Price component 10.94
Average WAS 1,15%
Bid-ask spread volatility 0,31%
Liquidity component 2.90
Liquidity Adjusted Value at Risk (euros) 13.84
% Liquidity Component 20.94%

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 Incorporating Liquidity Risk in Value at Risk Models

Appendix: The Weighted Average Spread

In 1994, a new block market was created to best meet domestic and international
investors' demand. Member firms are now allowed to buy and sell large blocks in a
single transaction and with a set price. This new rule is consistent with the recent
changes in French tax law: the FF 4,000 cap on stamp duty for transactions effective
after July 1993, and the complete exemption of non-residents from stamp duty since
January 1994.

The Stock Exchange Council selects eligible stocks. They include all component stocks
of the CAC 40 index and other stocks with market capitalization on a similar scale.

The number of shares in each transaction must exceed what is referred to as "Normal
Market Size", a figure based on average trade volumes in that stock. Total amount per
trade may not be less than FF 500,000.

Finally block trades must take place at a price which falls within the Weighted Average
Spread (WAS) for a standard-size block, as this results from visible buy and sell orders
placed through the CAC central trading system. This spread is calculated by adding up
orders within the system to reach standard block size and computing the average per
share.

TABLE A1
Weighted Average Spread Estimation (example)
CAC Central Market
XYZ 10.49 a.m.
TNB 15000 WAS 627 - 631
Buy-orders Sell orders
Quantity Price Price Quantity
3200 629 630 2560
2330 628 631 1780
2270 627 632 5020
2530 626 633 6370
4760 625 634 5870
Bid :
(3200*629) + (2330*628) + (2270*627) + (2530*626) + (4670*625) = 627
15000
Ask :
(2560*630) + (1780*631) + (5020*632) + (5640*633) = 631
15000

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 Incorporating Liquidity Risk in Value at Risk Models

In the example above (Table A1), the weighted average spread for 15,000 shares
representing the standard-size block of XYZ is 627-631.

Thus, member firms can execute orders representing quantities equal to or more than
15,000 shares at a price within the current WAS of 627 to 631. They do this either by a
cross-order or by acting as principal with their clients.

The Weighted Average Spread for each stock eligible for block trades is calculated and
disseminated on-line throughout the trading day.

Block trading reporting and disclosure:

- Block reporting is immediate: all block trades must be immediately reported to the
Paris Bourse by brokerage firm. If two member firms are involved, both must file a
declaration.

- Block disclosure: the disclosure to the market is immediate when a member firm acts
as a broker between two clients for a block trade. Otherwise, timing of disclosure
depends on the transaction's size: trades of blocks less than five times the Normal
Market Size are disclosed within two hours from the time they are reported. Trades of
blocks more than five times the normal market size are disclosed when the market opens
on the following business day.

Using this methodology, we get the figure 9 which shows us evolution of the visible and
the real Weighted Average Spreads (WAS) during the day.

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 Incorporating Liquidity Risk in Value at Risk Models

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