Defining Liquidity Risk ...

From: Glyn Holton
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Date: 20 Nov 2006
Time: 09:20:44

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Hi Andreas: I think we are struggling with how to define leverage. Ultimately, a definition should reflect how a word is used in practice. In the case of "leverage," usage seems varied. I don't have an adequate definition to offer. You offer a definition along the lines of "a leverage of 4:1 means that it takes an adverse market move of 25% to drive a portfolio/organisation into severe solvency issues." This has some nice elements. It makes leverage a function of the extent to which capital is at risk--without explicitly mentioning capital (which would require defining capital, which is another can of worms). A problem with the definition is the question "25% of what?" What do you mean by a 25% market move? You go on to comment "The situation is further complicated by the fact that two portfolios with exactly the same VaR (or VaR-to-reference-portfolio ratio) can have very different leverage in the sense of financial gearing." The word "gearing" appears frequently in the British literature but not in the American. I have always assumed that "gearing" was a synonym for "leverage," but maybe that is not the case. Please let me know. You mention two additional requirements that usually accompany implementations of UCITS III. The first, that "derivatives exposure have to be backed by liquid spot market 'underlying' positions," acknowledges that leverage is not risk, and that two portfolios may have the same leverage but different market risk. I just received a nice e-mail from Hilary Till, and she pointed out a piece by Martin de Sa'Pinto (*VaR at Risk? Models Required, Apply Within*, HedgeWorld, Oct. 31, 2006, password protected at http://www.hedgeworld.com/news/premium/read_news_printable.cgi?section=peop&story=peop2756.) is worth quoting: "leverage can be more or less risky, depending on the instruments used. A 300% leveraged fund that is largely held in U.S. Treasuries runs little danger of running into a liquidity trap ... But the same fund invested entirely in illiquid derivative instruments based on volatile underlying assets becomes highly risky ... In other words, there is leverage and leverage, and the same level of leverage can produce vastly different levels of risk." The second requirement that usually accompanies implementations of UCITS III, that "sophisticated" funds publish a market risk indicator (VaR) in order to create at least a minimum of transparency of market risks, is, as we have already discussed, problematic. If 99% 30-day VaR is used, and each fund has its own model, numbers will be all over the place. I suppose the regulator could specify its own standard VaR model to be used by all funds. Or, they could simply require that leverage be reported rather than VaR ...

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