Traditional methods to assess multi-asset portfolio trading risk do not generally consider liquidity risk but assume a perfect market. However, not paying attention to liquidity risk could lead to a considerable underestimation of total risk, especially in emerging markets, which tend to be more illiquid.

Now that developed economies have stagnated, investment funds and portfolio managers are once again looking to emerging markets and their attractive returns. On this type of illiquid market, liquidity-risk measuring tools take on a new importance, allowing risk and portfolio managers to assign a preferred liquidity horizon and to distribute rationally short- and long-term trading assets.

Models to assess liquidity risk (Liquidity-Adjusted Value at Risk – L-VaR) provide tactics for assigning assets to be used in trading portfolios in adverse market conditions. To estimate liquidity risks, in my research I have applied RiskMetricsÔ (J.P. Morgan), Al Janabi 1 and Al Janabi 2 models (the latter is known in specialized literature as the “Al Janabi Model”). I compare the results of these three models in different trade portfolios in my latest chapter, “Value at Risk Prediction under Illiquid Market Conditions: A Comparison of Alternative Modeling Strategies”, published in the book Risk Management in Emerging Markets: Issues, Framework, and Modeling.

I have focused on the relatively unexplored region of the Gulf Cooperation Council (GCC), made up of Saudi Arabia, Kuwait, Bahrain, Qatar, United Arab Emirates, and Oman, comparatively more-illiquid emerging economies. A daily dataset of market returns from these countries was selected. By applying different asset-liquidity models in a multivariable context and with financial and operational limiting factors, I found that, with certain trade strategies, such as short-sale stocks, the L-VaR model chosen for capital allocation is critical, especially during moments of crisis. In these emerging markets, not paying attention to liquidity trade risk could lead to considerable underestimation of risks.

Calculating liquid asset risk can be useful for any investor with a trade portfolio, as well as for financial institutions, as liquidity crises have been the force behind many bankruptcies. That is why more and more financial entities are using L-VaR techniques to measure the different trade risks. Specifically, they turn to custom-made internal risk-assessment models to respond to the traits of each institution.

The Basel Accords for controlling and measuring financial risk allow each financial institution to build its own internal risk model, so they can reserve their capital cushion against possible market turbulence. In fact, these internal risk models can be used to determine how capital financial institutions need to back their securities and comply with current risk-management regulations. If liquidity risk is not considered, financial institutions could use improperly their capital cushion, which is needed to absorb unexpected market shocks.

In general, asset liquidity trading risk stems from the difficulty in trading with it. This affects the ability of financial agents to trade or unwind their trading positions. Many insolvencies arise when financial bodies cannot get rid of their holdings, so the liquid value of the trade assets can differ considerably from the real market value.

Obviously, the growth in asset trading in emerging markets demands a reevaluation of market and liquidity risk-management techniques and methods, such as the L-VaR multivariate methodology, considering different liquidation and correlation factors, trade volumes, volatility prevision, and expected profit. As is suggested by the findings of this research, asset liquidity trading risk should be included in any performance assessment, as part of risk-adjusted compensation.

Traditional methods to assess multi-asset portfolio trading risk do not generally consider liquidity risk but assume a perfect market. However, not paying attention to liquidity risk could lead to a considerable underestimation of total risk, especially in emerging markets, which tend to be more illiquid.

Now that developed economies have stagnated, investment funds and portfolio managers are once again looking to emerging markets and their attractive returns. On this type of illiquid market, liquidity-risk measuring tools take on a new importance, allowing risk and portfolio managers to assign a preferred liquidity horizon and to distribute rationally short- and long-term trading assets.

Models to assess liquidity risk (Liquidity-Adjusted Value at Risk – L-VaR) provide tactics for assigning assets to be used in trading portfolios in adverse market conditions. To estimate liquidity risks, in my research I have applied RiskMetricsÔ (J.P. Morgan), Al Janabi 1 and Al Janabi 2 models (the latter is known in specialized literature as the “Al Janabi Model”). I compare the results of these three models in different trade portfolios in my latest chapter, “Value at Risk Prediction under Illiquid Market Conditions: A Comparison of Alternative Modeling Strategies”, published in the book Risk Management in Emerging Markets: Issues, Framework, and Modeling.

I have focused on the relatively unexplored region of the Gulf Cooperation Council (GCC), made up of Saudi Arabia, Kuwait, Bahrain, Qatar, United Arab Emirates, and Oman, comparatively more-illiquid emerging economies. A daily dataset of market returns from these countries was selected. By applying different asset-liquidity models in a multivariable context and with financial and operational limiting factors, I found that, with certain trade strategies, such as short-sale stocks, the L-VaR model chosen for capital allocation is critical, especially during moments of crisis. In these emerging markets, not paying attention to liquidity trade risk could lead to considerable underestimation of risks.

Calculating liquid asset risk can be useful for any investor with a trade portfolio, as well as for financial institutions, as liquidity crises have been the force behind many bankruptcies. That is why more and more financial entities are using L-VaR techniques to measure the different trade risks. Specifically, they turn to custom-made internal risk-assessment models to respond to the traits of each institution.

The Basel Accords for controlling and measuring financial risk allow each financial institution to build its own internal risk model, so they can reserve their capital cushion against possible market turbulence. In fact, these internal risk models can be used to determine how capital financial institutions need to back their securities and comply with current risk-management regulations. If liquidity risk is not considered, financial institutions could use improperly their capital cushion, which is needed to absorb unexpected market shocks.

In general, asset liquidity trading risk stems from the difficulty in trading with it. This affects the ability of financial agents to trade or unwind their trading positions. Many insolvencies arise when financial bodies cannot get rid of their holdings, so the liquid value of the trade assets can differ considerably from the real market value.

Obviously, the growth in asset trading in emerging markets demands a reevaluation of market and liquidity risk-management techniques and methods, such as the L-VaR multivariate methodology, considering different liquidation and correlation factors, trade volumes, volatility prevision, and expected profit. As is suggested by the findings of this research, asset liquidity trading risk should be included in any performance assessment, as part of risk-adjusted compensation.