Lecture Notes 1 | Long Term Capital Management | Market Liquidity

Lecture 1: Liquidity Risk

Dr.Gang Xu
Department of Economics University of Glasgow gang.xu@gla.ac.uk

August, 2010

In this lecture, we will discuss the liquidity risk from the perspectives of financial institution and regulators. By the end of the lecture, you should understand: The difference 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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make full payments in time Solvency refers to a company having more assets than liabilities.Liquidity and Solvency Liquidity refers to the ability of a company to make cash payments as they become due. then equity is positive Asset = Liability + Equity A solvent company may not have enough liquidity: Why? The answer can be found from Northern Rock (1) 3 / 28 . If assets are more than liabilities.

Liquidity Trading Risk 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 4 / 28 .

Liquidity Trading Risk Market Maker (Dealer) (2$ profits) Bid price (14$) Ask price (16$) Seller of IBM Shares Buyer of IBM Shares Middle Price = 15$ 5 / 28 .

(Why offer price is higher than bid price?) The bid-offer spread increases when the size of the trade increases.Liquidity Trading Risk Mid-market price of the asset is the mid price of the bid and offer (ask) price for an asset. Bid price: the price that a dealer is prepared to pay for an asset Offer (ask) price: the price that a dealer is offering to sell an asset Bid-offer (ask) spread: the amount by which the offer price exceeds the bid price. why? Do the size of bid-offer spreads tell us anything about the market liquidity? Low liquidity is normally evidenced by low trading volume and large bid-ask spreads 6 / 28 . why? Do the bid-offer spreads in the retail market show the same pattern to those in the wholesale market? If not.

Liquidity Trading Risk Bid and ask prices as a function of quantity transacted Price Ask price Bid price Quantity 7 / 28 .

China. India.Liquidity Trading Risk SBRY LN Equity (J Sainsbury PLC) Daily 1/2/2001 .P. BLOOMBERG Data and BLOOMBERG Order Management Systems (the “Services”) are owned and distributed locally by Bloomberg Finance L.12/30/2009 The BLOOMBERG PROFESSIONAL service. Japan and Korea 8 / 28 . (“BFLP”) and its subsidiaries in all jurisdictions other than Argentina. Bermuda.

BLOOMBERG BONDTRADER. BLOOMBERG PROFESSIONAL.Liquidity Trading Risk SBRY LN Equity (J Sainsbury PLC) Daily 1/2/2001 . 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. a Delaware limited partnership. BLP or their affiliates. BLOOMBERG Data and BLOOMBERG Order Management Systems (the “Services”) are owned and distributed locally by Bloomberg Finance L. 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. BLOOMBERG NEWS. BLOOMBERG TELEVISION.P.COM are trademarks and service marks of BFLP. BFLP. BLOOMBERG MARKET. BLOOMBERG ANYWHERE. BLOOMBERG TRADEBOOK. BLOOMBERG. BFLP is a wholly-owned subsidiary of Bloomberg L. BLOOMBERG PRESS and BLOOMBERG. which are available only to sophisticated institutional investors and only where necessary legal clearances have been obtained. (“BFLP”) and its subsidiaries in all jurisdictions other than Argentina. Bloomberg ®Charts 1-1 9 / 28 . China. (“BLP”). India.P.12/30/2009 The BLOOMBERG PROFESSIONAL service. Japan and Korea (the “BLP Countries”). The Services include electronic trading and order-routing services. BLOOMBERG RADIO. or its subsidiaries. Bermuda.

Liquidity Trading Risk Bid−Ask Spread for Sainsbury from 12/07/2000 − 30/12/2009 8 Dotcom bubble Burst 7 6 Terrorist Attack 5 Spread 4 Subprime Crisis 3 2 1 0 00 01 02 03 04 05 Time 06 07 08 09 10 10 / 28 .

but the liquidity for those assets can disappear very soon when things go wrong.6 billion of ABS CDO tranches (AAA rated) to Lone Star Funds for 22 cents in July 2008 Lesson learnt from the current crisis : Complex products that are not transparent can be traded in the normal time. One perspective to understand the current crisis: Very sophisticated financial derivatives which depend on the values of subprime mortgages etc are developed Rating agencies give those finance derivatives different ratings based on their risk exposures. because people don’t know how to value them 11 / 28 . but they trust the rating agency Now what if the rating agencies get things wrong? Merrill Lynch sold $ 30.Liquidity Trading Risk Liquidity also depends on the transparency. etc Market participants don’t understand how those derivatives are valued.

Liquidity Funding Risk 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 12 / 28 .

Securitization When banks lend money to borrowers. 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. they create loans which are the certificates entitling them to receive money from the borrowers in the future Instead of keeping loads on the banks’ own balance sheet. investors consider those mortgage backed assets too risky because the loans underlying those assets can not be paid in time 13 / 28 .

Securitization Borrower loans money Bank (Creating new securities backed by the loans) Financial engineering New securities Investor money Question: Does the bank have motivations to check the creditworthiness of the borrower when it originates the loan? 14 / 28 .

Borrowing from central bank needs collateral: If a commercial bank wants to borrow money from central bank and puts a collaterial worth 10 million. central banks have broadened the range of collaterals accepted in order to add liquidity into the market 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. why central banks concerned about the failure of investment banks? 15 / 28 . the Federal Reserve Board extended its borrowing facility to investment banks as well as commercial banks.Central Bank Borrowing Central banks are referred to as “lenders of last resort”. it might get 8 million from the central bank (discount applied) During the subprime crisis.

then there will be massive bankruptcies and bank runs which could paralyse the whole economy Key Question: What is the right distribution of responsibility for liquidity management between commercial banks and central banks? 16 / 28 . it will send the signals to the market that central bank will help with the liquidity management during the crisis. then why would the commercial banks bother with the liquidity management themselves when the central bank will do so If Bank of England doesn’t help the Northern Rock.Central Bank Borrowing The dilemma faced by the Bank of England during Northern Rock crisis is that: If Bank of England immediately helps the Northern Rock.

others realize it and will sell it at even lower price The danger in the financial market is at a time when everyone wants to sell. But how could this happen? The crash of 1987 17 / 28 . no buyers.Liquidity Black Holes 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 find everyone else wants to sell this asset as well You will sell the asset at a lower price.

Negative feedback traders: Buy when prices fall and sell when prices rise Positive feedback traders: Buy when prices rise and sell when prices fall 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? 18 / 28 .Liquidity Black Holes Liquidity in the market is driven by the behaviour of traders.

Liquidity Black Holes Financial regulations are a form of regulation or supervision. The financial regulation body in UK is Financial Service Authority What are the risks for all the financial 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 Different financial institutions should be regulated in different ways or by different regulation bodies 19 / 28 . which subjects financial institutions to certain requirements. restrictions and guidelines. aiming to maintain the integrity of the financial system.

Liquidity Black Holes Leveraging: individual and companies increase their borrowings: Financial Leverage = Debt Equity 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 20 / 28 .

liquidity black holes Irrational exuberance can explain many financial crisis: 1987 stock market crash 1994 bond market crash 1997-8 Asian monetary crisis 1998 Long-Term capital Management failure 2007 subprime crisis Discussion: how trader’s compensation can exacerbate the irrational exuberance? 21 / 28 .Liquidity Black Holes Irrational exuberance was coined by Allan Greenspan in December 1996 Irrational exuberance refers to the traders in different financial institutions become irrationally exuberant about a particular asset class. which results in the dramatic increase of its prices All the traders start selling that assets at the same time when the bubble busts.

Russia defaulted on its government bonds which distorted the whole financial market. Harvard etc to construct extremely complicated mathematical pricing and hedging models. 22 / 28 . it was then bailed out by the Federal Reserve and the fund was finally closed in early 2000.6 billion dollars in just 4 months. The government bonds are normally considered as risk free assets. both of whom won the Nobel Prize in 1997. However in 1998. LTCM recruited the science PhDs from MIT. Its annualized return of return (after fees) in its first years reached the level of 40%.Long Term Capital Management (LTCM) LTCM is founded by John Meriwether in 1994. However during the 1997 Asian financial Crisis. LTCM lost 4. its boarders of directors include Myron Scholes and Robert Merton.

particularly during the crisis period The Financial Service Authority (FSA) banned short selling during the credit crunch Recently.Long and Short Position Long position: a position involving the purchase of an asset: Long positive gains when asset price moves up Short position: a position assumed when traders sell shares they don’t 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. the German government banned short selling on government bonds Question: Shall we totally abandon the short selling? 23 / 28 .

The broker sells the share to the market at 15$ 2.Investor A instructs a broker that he (she) wants to short an IBM share (15$) 4.The broker borrows a share from investor B Question: If the IBM share distributes dividends.The broker returns 15$ to the investor A Investor B broker 3.Short Selling: Today Investor A 1. who should get it. investor A or investor B? The Market 24 / 28 .

Short Selling: One Month Later 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 25 / 28 .

The Collapse of Long Term Capital Management Long Term Capital Management adopted the trading strategy called convergence arbitrage: Trading philosophy: identify two securities that should have the same theoretical values. then their prices should eventually be the same Trading Strategies: Long the illiquid bonds (corporate bonds) and short the liquid bonds (government bonds) with the same properties However. LTCM is highly leveraged. Russia defaulted on its treasury bond which results in flight to quality in security market The spread between the liquid bonds and illiquid bonds widened dramatically. If they have the same theoretical values. so it goes bankrupt because it can’t meet the marginal requirements Discussion: do we see the flight to quality under the current subprime crisis? 26 / 28 . if their prices are different. then they long the security with low prices and short the security with high price.

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 27 / 28 .

the investor pocket the profits today.Convergence Arbitrage (LTCM) Long illiquid corporate bond What happened to LTCM is that the bond prices diverged before their convergence. which are the difference between the liquid and illiquid bonds 28 / 28 . which trigged substantial amount of marginal calls Investor Short liquid government bond Since the prices for the illiquid Bonds are lower.

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