Underestimating liquidity risks: How investors can suffer

Risk management models used by professional investors often assume that securities can be traded infinitely. When liquidity dries up, especially in a systemic way during periods of crisis, it becomes very expensive to trade

"When there is rain, umbrellas become expensive. But when there is no rain, nobody cares about the umbrella and the prices are low. The case of Liquidity is similar", says Professor Yakov Amihud, Ira Rennert Professor of Entrepreneurial Finance at the Stern School of Business, New York University. Prof Amihud has been actively researching the effects of liquidity of assets on their returns and values, and the design and evaluation of securities markets' trading methods for over three decades.
 

In conversation with Dr Nupur Pavan Bang of the Insurance Information Bureau of India and Prof Vikram Kuriyan of the Indian School of Business, Prof Amihud explains that liquidity risk is often ignored by investors. Risk management models used by professional investors often assume that securities can be traded infinitely. When liquidity dries up, especially in a systemic way during periods of crisis, it becomes very expensive to trade.

Firms like Morgan Stanley and Long Term Capital Management have suffered huge losses due to underestimating the cost of liquidity.
 

So when does liquidity dry up? "It is a chicken and egg story", says Prof Amihud. When prices fall, traders with leveraged positions need to come up with additional funds. If funding is too costly, traders must liquidate part of their positions and this makes stocks less liquid. When stocks become illiquid, their prices fall further; this exacerbates the problem of illiquidity. In addition, information asymmetry is an important determinant of illiquidity. When there is overall panic and information gaps between traders widen, transaction costs go up and liquidity dries up.
 

The introduction of high frequency trading (HFT), algorithmic trading and technology improvements in terms of direct market access and co-location has not hurt the markets in terms of overall liquidity. Every generation, there are some people who are more technologically advanced than the others and consequently they have an advantage over the others. In earlier times, people who had telephones had an advantage over those who did not have telephones. Then came computers. Initially, only a few had computers. Now, everyone has it.
 

It's not an arms race, which imposes a dead-weight cost with no benefit. For example, when both India and Pakistan did not have nuclear weapons, they were equal. Now both have it, and they are still equal, but after burning billions of dollars. Similarly, people argue that when there was no HFT every one was equal in terms of technology. And now with HFT, everyone might eventually reach there and then again everyone will be equal. So why have it? Well, by improving the speed of transactions, HFT helps improve stock liquidity. Limit orders are tighter (have narrower gap between the buying and selling price), which benefits all traders who can trade at lower cost. This applies particularly, to large and more liquid stocks, in which HFTs are more actively involved.

The level of illiquidity and its price have declined over time. This is not an anomaly which will disappear once the market finds out about it. It will stay there and benefit all traders and the economy at large.
 

On being asked about liquidity in the Indian markets, Prof Amihud says that India is among the least liquid markets in the world. Ironically the corporate world would get upset if the Reserve Bank of India (RBI) would raise bank interest rates. Yet, they are not worried about the illiquidity in the securities markets, which raises their cost of capital. If the Securities Exchange Board of India (SEBI) comes out with a regulatory scheme that would make the market more liquid, it will reduce the corporate cost of capital, akin to the RBI lowering interest rates.

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    COMMENTS

    Abhas Bhushan

    7 years ago

    With all due respect to the authors and the comments herein my take is –
    The article very well describes and captures the effect of liquidity with the example of rain and umbrella. No where the article says that it is the only factor affecting fall / rise of scrips but yes it is one of the most underestimated factor. Someone pointed out LTCM’s example – if u read the book “When Genius Failed” – u’ll find that the liquidity was the sole factor (and effects emanating from it) for the birth of LTCM let alone reasons for fall of LTCM.
    No-one is denying that counter-party risk is a major risk but have we not in our lives as well experienced the effect of Liquidity / illiquidity? Can we ignore the basic principal of economics related to velocity of money; if u keep on taking out money and store it (causing illiquidity in the market) will it function the same way as it should be??
    Trading of any kind is dependent on buyers and sellers and hence demand and supply; buyers and sellers will always be there...but the point being made in the article is that there is a cost associated to being able to buy or sell.

    REPLY

    Santosh Kanekar

    In Reply to Abhas Bhushan 7 years ago

    1. Liquidity is the effect not the cause - that is what I'm trying to point out

    2. In cash markets esp in India, short selling is allowed only intraday and non-futures market is subject to Daily limits beyond which trading stops. So there is no issue of liquidity here. As much free float is present, there will be "liquidity"

    3. In Futures (cash settled futures) again the exchange places a limit on Open Interest which is related to the Free float. no liquidity problems here.

    4. The problem starts in Options where Open interest can be written unlimited esp in Index futures. The problem is not liquidity - the problem is counter party risk. If people write 1L crore options and the underlying is 5k crore then if delivery is asked for,then, it becomes a problem. If cash settled no problem

    5. India is one of the TOP 5 stock exchanges in the world! in terms of number of contracts executed every day so how is it a illiquid market?

    6. the most liquid market ie US froze with the AIG crisis. why? coz when CDS which were sold (which were nothing but put options) were asked to be delivered, AIG came into a counter party risk and liquidity froze.

    7. Money is fungible. dont confuse velocity with quantum. cash whether it sits in a drawer or buy a share is liquid as long as there is another party to take transaction - counter party

    hope this clarifies

    Vinay Joshi

    In Reply to Abhas Bhushan 7 years ago

    Hello,

    In the first place the authours of this article have various mind thoughts, getting - irrational nuclear aspects - in their 'so called supportive', bid to establish a point.

    In that event i can also talk of AK-47 inventor [ i know neither the authours will know details].

    How much is velocity of money? Not directly related to M3? What is M3?

    Today BSE/NSE trading at 13x why NONE CAN STEP IN TO BUY? ANY LIQUIDITY PROBLEM?

    No Its not liquidity, 'FRAGILE FIVE', as the investors see is the concern!? OK!

    C'mon authors answer as you all are professionals, Ms.Nupur, Mr.Vikram.

    Regards,

    Vinay Joshi

    In Reply to Abhas Bhushan 7 years ago

    Hello,

    In the first place the authours of this article have various mind thoughts, getting - irrational nuclear aspects - in their 'so called supportive', bid to establish a point.

    In that event i can also talk of AK-47 inventor [ i know neither the authours will know details].

    How much is velocity of money? Not directly related to M3? What is M3?

    Today BSE/NSE trading at 13x why NONE CAN STEP IN TO BUY? ANY LIQUIDITY PROBLEM?

    No Its not liquidity, 'FRAGILE FIVE', as the investors see is the concern!? OK!

    C'mon authors answer as you all are professionals, Ms.Nupur, Mr.Vikram.

    Regards,

    Santosh Kanekar

    7 years ago

    An unnecessary attempt to complicate things.

    Prices are a reflection of Demand and Supply and the volume available. If someone can "liquidate" that means there is a seller and there is a buyer and volume is available.

    LTCM and London whale (not mentioned but same category) happened because the trades taken were sound but they took up positions which were very large. When other traders found that out, they stopped buying the options which were being sold causing a counter-party risk and "freezing" of the market. This was more a predatory trading tactic than a "systemic" issue.

    Margin calls also cause the same symptoms without liquidity being an issue eg 400 tons sell off in Gold which happened in 2013 and two days back Natural Gas sharp correction which happened.

    The bigger "systemic" issue is Counter-party risk or the creation of contracts with no one to honor them. The biggest issue the world faces today are ETFs (esp the inverse ETFs) and Credit Default swaps: both have reached proportions far in excess of the underlying. In India, it is the derivatives market. On a high volume day, NSE records cash transaction of 5000 cr and Options turnover of 1 lakh crore!

    REPLY

    Vinay Joshi

    In Reply to Santosh Kanekar 7 years ago

    Mr.Santosh,

    Absolutely pointed it out to London Whale, now what the authours can state?

    When oil was $145, the derivatives & futures were more in volume value expansion than all the stock indices put together world over!
    Liquidity was always there!

    Silver was high coz of margins imposed lowered.

    JP Morgan is acceding to record $13bn settlement with regulators on mortgage securities! [as reported by WSJ].

    I'm not going into banking industry settlements, US alone it is 100's of bns.

    I hope the authours of the article answer!

    Regards,

    Vinay Joshi

    7 years ago

    Dr. Nupur Pavan Bang & Prof.Vikram Kuriyan,

    If traders are liquidating how liquidity will be an aspect?

    Entrepreneurial finance is different from traded securities liquidity.

    Ms.Nupur & Mr.Vikram, at the start of the week world over all indices had slipped! Today Dow & Nasdaq lowest.

    Why is India's premium over other emerging markets rising?

    PEx MSCI India is 105.30 against PEx MSCI for Emerging markets 86.79 - Jan 1 2013 to Jan 24 2014! In other words the valuation gap is widening.

    Now where does your theory get into & fit to advance a thought line of liquidity? Kindly explain.

    Indian scrips can't be immune to global contagion but can be vulnerable to other parameters in economy stability in next couple of months.

    I hope you've heard of Premise Data Corp; a fledgling data collection & analysis co. based out of San Francisco, funding from Google Ventures,Andreesen Horowitz, Harrison Metal, Google computer scientist Joe Reisinger & Quant Analyst David Soloff.

    As of now they are not putting any figure on liquidity but David Soloff is more interested, Prof. Amihud.

    So in system theory, liquidity just a concept to stock reference.

    Regards,

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