Friday, 31 August 2007

Liquidity Dynamics

Three pieces of recent news seem interlinked. Barclays used the Bank of England window to buy in liquidity at a penal rate. The president of Moody's thinks that what we're experiencing is an extreme lack of confidence and lack of liquidity. I have never seen this before. And the CP market is still shrinking.

This highlights the importance of liquidity and suggests that it would be interesting to incorporate liquidity dynamics into models of market returns. A model that just accounts for asset returns is not that useful in many cases if the implicit assumption is that prices can fall but you can still sell. The reality in many securities at the moment is that the holders strongly suspect that prices have fallen but they have no real idea because there is no liquidity.

Extreme value theory might account for the tail of the return distribution well for liquid assets like the S&P 500 future, but it isn't much use by itself if it tells you your ABS can fall by 50%. For many securities a large fall in value implies extreme illiquidity and hence a large measure of uncertainty as to the right mark to market. So the possibility of a 50% fall is not a useful quantification. Instead it would be useful to have a theory that says 'today your ABS is worth 98 +/-1 and you can sell it in a day. In a year at 99% confidence it might be worth 50 +/- 25 and if it has fallen that far, you can sell it in three months'.

Finally, some real liquidity, from the Wild Coast of South Africa.

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