A Perspective on Liquidity Risk and Horizon Uncertainty

Abstract

For decades, the standard deviation of investment returns and beta have been the dominant risk metrics and guideposts for building portfolios of risky assets, but these risk measures have provided little help in explaining the cross-asset and cross-market volatility experienced over the last two years. The most recent spate of selling-contagion arose largely as a result of fund flows across asset classes. These flows were related to the urgent and large need to reduce risk and leverage by those investors who found themselves on the brink of financial ruin as a result of losses incurred. The author explores a common source of tail risk—specifically, episodes of extreme liquidity scarcity associated with horizon uncertainty—as well as the correlation across the cash flow demands of market participants and the short-run constraints on market-making capital. Liquidity risk is often high after a long period of abundant liquidity driven by low fundamental volatility, rising economic growth, and returns with trending patterns. Long option positions provide a natural hedge for liquidity risk, generating profits and losses based on the underlying security’s price movement without any need to trade as well as from the likely increased volatility premium.

TOPICS: Portfolio construction, tail risks, volatility measures, financial crises and financial market history