Liquidity Risk Related to Financial Transactions

Abstract

In any financial transaction, the parties try to get the best possible result by taking into account information on the features of the operation and on the liquidity of that particular financial instrument. To that effect, the size of the package of financial instruments to be sold/purchased, the time frame for the operation to be completed, and the target price of the transaction, will all be taken into account. As regards the liquidity of the market of that particular financial instrument, the reference/market price of the financial instrument, the costs relevant to the transaction, the market depth, the volume of traded instruments, and the value of the transactions concluded during the previous period, etc. shall be taken into account. The liquidity risk can be regarded as that part of the value of a transaction that could not be obtained by an investor/a financial entity, according to his/its calculations made before concluding the operation, because the transaction was too large and was concluded within a very short time as compared to the market depth. In other words, if a large transaction does not take the market depth into account, a lower price than the targeted one will be obtained. In the following, we are going to present an assessment methodology for the liquidity risk attached to transactions, as well as various methods to keep the impact of this risk at insignificant levels. These methodologies for the assessment and reduction of the liquidity risk attached to financial transactions could be used by various financial entities involved in financial trading or financial asset portfolios administration activities. Also, these methodologies can be adapted and used by the market infrastructure entities or by the IT companies that develop trading or risk management applications for financial entities.