Liquidity Risk and Other Non-Market Risks › Summary

This chapter has explored the risks that operate beyond traditional market risk measures, revealing vulnerabilities that quantitative models often miss.

Market liquidity risk arises from the inability to transact without significant price impact. Bid-ask spreads, market depth, and the square-root law of market impact provide frameworks for understanding and measuring liquidity costs. Position limits based on average daily volume help ensure portfolios can be liquidated within acceptable timeframes.

Funding liquidity risk concerns the ability to meet cash obligations. Margin calls, redemptions, and debt rollovers can create simultaneous cash demands precisely when asset markets are stressed. The feedback loop between funding and market liquidity can transform modest market declines into full-scale crises, as demonstrated during LTCM's collapse and the 2008 financial crisis.

Operational risk encompasses losses from process failures, human error, systems breakdowns, and external events. While difficult to quantify due to the heterogeneous and heavy-tailed nature of operational losses, frameworks exist for estimating operational risk capital and, more importantly, for identifying and mitigating operational vulnerabilities.

Model risk emerges from the quantitative frameworks we use to measure other risks. Incorrect specifications, calibration errors, implementation bugs, and inappropriate applications can cause models to fail precisely when they are most needed. Independent validation, ongoing backtesting, and explicit documentation of model limitations provide defenses against model risk.

Qualitative assessment complements quantitative measures for risks that resist easy quantification. Scenario analysis explores vulnerabilities that historical data may not reveal. Expert judgment identifies emerging risks before they appear in loss data. Risk culture ensures that organizational incentives align with prudent risk-taking.

The next chapter examines how these risk measures and assessments are integrated into coherent risk management policies and practices at the institutional level, addressing governance structures, limit frameworks, and the practical challenges of implementing risk management in complex organizations.