Measuring Liquidity Risk

Abstract

In the first two parts of this book we have considered why liquidity is so vital to corporate operations and illustrated what can go wrong, in theory and practice, if it is mishandled. The degree of financial damage that can arise varies. In some cases it may be limited to losses from higher funding costs or asset disposals at prices below carrying value; in other cases it may be more serious, extending ultimately to instances of financial distress and insolvency. Every entity exposed to liquidity risk must therefore attempt to avoid damage through a liquidity risk management process. An effective framework, our topic in this part of the text, is based on a number of fundamental elements. In this chapter we discuss the measurement of liquidity risk through various tools, in Chapter 9 we consider ways of managing liquidity risk as part of the corporate process, and in Chapter 10 we discuss the development and implementation of a liquidity crisis management plan. In Chapter 11 we consider various new regulatory initiatives that have been developed in the wake of the financial crisis of 2007–2008; we summarize key thoughts on active liquidity risk management in Chapter 12.