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Liquidity, Market risk and Credit risk


While the relationship was always intuitively understood by traders and risk managers, it remained widely ignored in practice until the global financial crash brought the system to the brink of collapse. Having deconstructed the events of 2008, the financial service industry, driven by policymakers and regulators, now integrates credit risks in valuations and profit/loss (P/L) calculations, and hedging, funding, capital and balance sheet management.

Value adjustments based on quantitative credit assessments are certainly a major step toward integrating credit costs in the absence of a default event. Yet it remains a one-dimensional approach to funding costs and capital utilization. It would provide a false sense of safety if the regulators endorsed it as a universal methodology, as they once did for value at risk (VaR).

The problem is that quantitative approaches essentially rely on assumptions and calibrations, both resulting from historical data. Monte Carlo simulations, in particular, typically miss serial correlations in returns, mean reversions, liquidity holes and cross-asset risk externalizations.

“No model has yet captured the fact that the future is not rooted in the past; it is a reaction to the present.”
In the words of Avinash Persaud

In recent weeks, for example, a series of tail events in energy prices, foreign exchange and monetary policy decisions might have invalidated a large number of stress scenarios and Monte Carlo paths. While the changes in market prices are immediately visible, the potential impact on the counterparties’ portfolios will not be known until credit events provide the information.

The question is, how can financial institutions truly assess the potential impact of market risk on credit exposure, and how both intertwined create market shocks or tail events? The answer lies in alternative types of analysis undertaken by some financial institutions, which consider the global effects of risk factors on their ecosystems - not merely their sole operations - and in a liquidity-driven approach to pricing and valuation risks.

Extracto del artículo Liquidity: the missing link between market and credit risk de Philippe Carrel, Director General de Calypso Technology, para la revista Trading & Risk Magazine, en el 3er número de 2015.


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