The global financial crisis showed us that there is a need for appropriate identification and evaluation of implicit liquidity trading risks in investment portfolios. It is undeniable that many of the financial institution collapses, both in developed and emerging markets, as well as the subsequent financial turbulence, were, to a certain point, caused by the impact of liquidity trading risk on the structured share portfolios.
Liquidity trading risk increases due to the incapability of financial institutions to liquidate their shares at a fair price during the settlement period.
In the chapter “Liquidity risk management in emerging and Islamic markets” that I published as part of the Handbook of Empirical Research on Islam and Economic Life (Edward Elgar, 2017), I empirically develop and test a strategy of measurement and exposure control of market/liquidity risks of investment portfolios that include illiquid capital shares in critical circumstances, proposing that there be a strategy for the establishment of maximum risk limits.
The market risk of a trading position is the risk of a shift in value of the position due to unexpected market variables or other similar affecting factors, such as stock index levels or individual shares.
In order to evaluate the risks involved in their trading operations, the main financial institutions are increasingly adopting Value at Risk [VaR] techniques and models. They are also adapting each of their individual features. There is no right or wrong way to measure or manage liquidity risk. It all depends on the individual objectives of each institution, their lines of business, their risk appetite and the funds available to invest in risk management projects.
Despite much criticism and restrictions, the VaR method has proven to be very useful in the measurement of market risk, and is widely used in both financial and non-financial markets.
Throughout the chapter I establish a practical framework for risk measurement, management and control, including the effects of illiquid shares which are typical in the emerging and Islamic markets. These liquidity shortfall effects must be treated with the utmost caution, and be included into the optimizing risk L-VaR framework.
The results of this study suggest that there is an inevitability of combining L-VaR evaluations with other methods, such as scenario analysis and stress testing to obtain a full view of other existing risks. In contrast to other liquidity models commonly used, the strategy implemented in this study is more suitable, as it takes into consideration the daily sales of small fractions of the investment assets from short and long-term sales.
In the last few years there has been a notable improvement in the adopting of risk and regulation management cultures among local financial institutions and regulatory institutions.
This methodology and the optimistic algorithms of risk evaluation represent progress in the practicing of trading risk management in emerging and Islamic markets, especially in the wake of the previous credit crisis and the consequential financial shocks.
