Liquidity Risk

[Gareth]

Does anyone know how you would quantify liquidity risk in the allocation of risk capital?

I can see perhaps you might look at the increase in capital when moving from a matching portfolio to strategic asset portolio. But I am looking at volatile P&C business, so it's not as if a matching portfolio will always exist or be easily identifiable.

Any ideas or papers you might know of?

[Run2standstill]

How do you get your risk captial in the first place? If it is determined by a "vaR" type of calculation through MC simulation, one way to quantify the liquidity risk is to change parameters through the simulation assuming a liquidity issue, for example, lower asset returns, higher vol (liquidity crunch often leads to higher vol), policy holder behavior if applicable. There are papers and studies on each of the above items, so that you can somewhat justify and calibrate the parameter changes. Then the difference between the two runs will help to identify liquidity impact.

[DixieFlyer]

there's an interesting article on page 1 of this morning's WSJ talking about problems with pricing many securities, particularly those in Level 2 or Level 3...if you were forced to sell them, you may get a much lower price than the value that you are carrying them on your books...the article cited an example where Wachovia got 10 cents on the $ for a CDO it sold this summer

[Gareth]

I using MC simulation. It seems this is not a well researched area.

In theory if you work out the risk capital as say 99.5% VaR on the surplus process, you can allocate the capital to underwriting risk, market risk, currency risk, liquidity risk etc.

While it's simple to work out market risk, there's virtually no literature on how to properly allocate the element due to liquidity risk.

I'm sure there's a few consultants who have figured out a more precise approach than looking at specific scenarios...

another approach that i've seen mentioned is assuming you cannot realise your entire long term asset portfolio for say 30 days. The liquidity risk is then defined as the costs of borrowing the MV of your long term asset portfolio for 30 days.

All seems very arbitrary to me.