Market Liquidity Risk

Liquidity is important and necessary. Liquidity is an assumed characteristic of a well-functioning market, but we only pay attention to it when it is absent—like the proverbial umbrella that is missing when it rains.¹ What is market liquidity? Can we measure market liquidity? Can we manage market liquidity?

During noncrisis times, buyers and sellers usually show up in most markets to trade, and they can all go on to do what they usually do: invest, hedge, and speculate. During such noncrisis times, regulators monitor financial markets using established policy frameworks.

Markets match buyers and sellers, and enable the formation of security prices. The viability of a market therefore depends on how well buyers and sellers are matched and how accurately the trade price evolves. Matching implies the provision of liquidity. In classical finance theory, this conjures an image of the Walrasian auctioneer letting the hammer down on the final auction price. In real-world financial markets, the role of the auctioneer is fulfilled by the market maker or financial intermediary. But liquidity also arises from other aspects of the trading mechanism that are determined by the institutional framework and structure of a particular market, which in turn are determined by rules and regulations that govern trade and interaction between market participants.

Traditional asset pricing models are based on the notion that aggregate market risks rather than individual risks are priced in a market that has reached an equilibrium between supply and demand from participants. The assets prices under this paradigm generally agree with the fundamental value of the asset, and all you need for asset pricing is knowledge of the cash flows or payoff and a specification of the discount factor. This traditional economic paradigm, discussed in chapter 1, further assumes that markets are frictionless, or perfectly liquid, and that capital is freely available. Yet this traditional paradigm has limited ability to explain empirically observed market behaviour because it either dismisses the issue of market liquidity as a friction or accounts for market liquidity by adding a transaction cost to the fundamental value. Market liquidity is typically incorporated as an exogenous transaction cost—an afterthought to asset pricing. The simplicity of this view is appealing, and for the ignorant market participant it may be sufficient. It acknowledges the difference between the transaction price and the fundamental value of an asset, and further attributes this difference to the costs of trading. Incidentally, adding trading costs violates the basic assumption of frictionless markets on which most classical asset pricing models are based.

In 1959, Professor Lawrence Fisher¹ presented a hypothesis about the determinants of the risk premium on corporate bonds.² Fisher showed that the average risk premium, defined as the yield differential between a corporate bond and the risk-free rate, depends on two factors. The first factor reflects the default risk or creditworthiness of the issuer. It captures the basic idea that the lender will get their money back. Incidentally, this factor has dominated our thinking about bonds in general and corporate bonds in particular. But Fisher also considered the “marketability” or liquidity of the bond, defined as the market value of the firms outstanding bonds traded in the secondary market, to contribute to the risk premium.³ If Fisher introduced the idea of “marketability” in the middle of the last century, why have we for the most part ignored bond market liquidity?

The celebrated author Peter Bernstein explained in his book Capital Ideas: The Improbable Origins of Modern Wall Street, “Without the stock market, the market for corporate ownership would be like the market for houses. Agents have to advertise or use some cumbersome method of finding the other side of the deal. Real estate agents earn commissions of 6% or more, while the commission on a typical stock transaction is less than 1%. After the house has been sold, only the principles and their close friends know what the price was.”¹ The increased marketability of financial instruments and the transferability of risks have been one of the major features of the modernization of the financial system and our increased reliance on a liquid market for smooth operation of the financial system.