Liquidity on the outside from the inside

Abstract

We describe an extension to a Liquidity-Adjusted Value-at-Risk (LVaR) model originally developed by Bangia et al. (1999) that incorporates liquidity risk into the traditional VaR model using random bid–ask spreads. By applying the Hellinger distance measure, we show how the bid–ask spread can be partially endogenized by adjusting it to reflect the influence of trade size on prices and ultimately on the measurement of market risk.

Keywords:

• VaR
• liquidity
• bid–ask spread

JEL Classification:

• C60
• G10

Acknowledgments

This article contains the current opinions of the author and not necessarily those of PIMCO (Pacific Investment Management Company LLC). These opinions are subject to change without notice.