Liquidity ALM or Market Risk ?

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Liquidity ALM or Market Risk ?
Jérôme Lebuchoux
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Liquidity

• Vague concept ?
• Standard approach
• Related to market liquidity on asset (volume,
  trades, prices, etc)
• microstructure
• Major risk
• Macro impact
• Credit crunch
• Crisis

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Market liquidity

• Classical approach for liquidity
• Execution price depends on the volume
• Execution
• Take into account the asymmetry (buy and sell)
• Optimal execution model for block trade
• Allocation
• Rebalance the portfolio according to the
  liquidity
• Risk
• Gap risk
• Limits
• It is a vision of liquidity related to buy / sell
  action

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Market liquidity

• The regulators are imposing new constraints
• New pools of liquidity have emerged
• New exchanges
• Dark pool
• Long term investors
• This approach is not appropriate for many markets
  (Fixed income)
• Is there something else ?

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Market liquidity

• Investors are not operating with the same
  objective nor under the same rules
• Pension funds
• Hedge fund
• Insurance
• The buy and sell are only the visible actions but
  behind every operations there is a financing part
• Cash
• Margin
• Borrow
• Collateral

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Examples

• Buy a future at an exchange
• Post the initial margin
• Sell short a financial stock
• Borrow the stock
• Buy a swap
• Post collateral

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ALM liquidity

• If there is no financing there is no investment
• If one could not buy it may be able to borrow
• If one could not sell it may be able to repo or
  post for collateral
• Example Corporate bonds
• No price on secondary market
• Accepted as collateral
• Borrow money, post the bond as collateral and
  invest into new asset
• Spread position
• Borrowing cost, repo market are good indicators
  for liquidity, it could be used to get a long or
  a short position on liquidity on FI market.

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Hedge Fund

• Hedge Fund utility ?
• Optimal Capital allocation
• Diversification
• Arbitrage
• New risk profile
• Liquidity provider
• To the Market
• To the investors

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Facts

• Old concept but a young industry
• Asset Management industry has been hit by the
  crisis
• Asset under management has been reduced.
• Performance was poor.
• Risk management has shown its limits
• Authorities are putting pressure for new
  standards and regulation.
• The confidence of the investors is low
• Consequences
• Revenues are declining
• Customers are more demanding
• The image of the industry is deteriorated

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A step back

• Main drivers of the asset management industry
• Economy
• Growth of economy
• Capital needs to sustain the economy growth and
  restructuring
• Demography
• Life expectancy
• Human capital growth
• Globalization
• Free trade
• Communication and mobility
• Politics
• Tax regime Labour / Capital
• Social security vs individual savings

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Hope

• An evolution or a revolution ?
• Only the first point (Economy) is directly
  impacted by the crisis
• There are second order effects on the other
  points
• Returns of protectionism
• Nationalisation of the economies
• Political instability
• World AL balance has evolved (geographically,
  private/public) but is growing
• A threat or an opportunity ?
• Adequacy between the offer and the demand has
  been challenged
• Leaders are under pressure and Darwinism is
  ongoing
• Our opinion
• The asset management starts restructuring
• The window for change and opportunity is now

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AUM Actors

• A steady increase of AUM and of number of HF
  until 2007the crisis changes the picture

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Performance

• The decorrelation of the HF performance with the
  indexes in question

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Alternative investment and liquidity crisis

• The financial crisis impacts the HF industry
• A performance issue
• Weak and correlated performance
• Limited number of strategies
• Small capacity wrt performance impact
• Poor liquidity
• Limited financing facility
• Illiquidity of the underlying
• Investors on hold
• Fall in AUM
• Investors raise their standards

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Liquidity risk

• Hedge fund are
• Long correlation in stable market and short the
  systemic correlation
• Long the spread of liquidity between investors -
  market
• Standard Liquidity indicators
• Market impact
• Number of days to close the positions
• Features to manage the liquidity
• Lock up
• Gates
• Unfortunately the set up of the fund have been
  made according to
• Market practice Lock up
• Emergency Gates
• But not wrt the real liquidity risk

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An asymmetric risk / bubble

• A toy example
• Fund with a stock X in illiquid asset (price
  impact / NAV)
• Buy an extra x of asset -gt move the price up by
  y -gt NAV of fund y on the full AUM
• Sell x of asset -gt move the price
  down by -y -gt NAV of fund - y on the full
  AUM
• A liquidity trap / gap risk
• It is always easier to buy than to sell

Tomatoes producer
buy
Tomatoes fund
NAV
New investment
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A simple framework

• Needs to move from a pure performance / risk
  model to an Asset and Liability model (which is
  the difference between the PL and the NAV)
• Liability Investors, fees, etc
• Asset investment
• Model of investors portfolio
• Each investors and prospects are ranked wrt its
  category, size of investment and probability to
  invest or redeem.
• Today AUM 100 M, new potential investors 5 M

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A simple framework

• Model simple copula with three parameters
• One correlation intra category
• One correlation extra category
• One correlation existing / new investors
• At a given date (1M or according to fund
  liquidity) we get the pdf of the AUM
• Avg AUM 94 M

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Allocation model

• Portfolio model
• One risky and non risky asset, no rate and
  dividend, simple BS model
• One period model
• At the end of the period the AUM is impacted by
  the redemption and the new investment
• Rebalancing without impacting the portfolio risk
  profile
• Where is the growth of the AUM

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Allocation model

• Cost of rebalancing according to an average
  liquidity L
• Optimal portfolio
• Utility function
• Special case

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Intuitive approach

• The optimal allocation leads to an option on AUM
• The optimal allocation accounts for the hedge of
  the option
• The optimal allocation could be seen as the
  classical allocation minus the risk on the spread
  AUM / Asset

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Simple model result

• Target allocation in risky asset 55
• Beta 10
• L 20
• Change in risky asset allocation
• If the proba of redemption increases, the
  investment in risky asset should decrease
• If the investors are correlated, the investment
  in risky asset should decrease

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Combined model

• We have looked at a single asset manager, now we
  explore the case of multiple managers trading the
  same asset
• N agents, they share the liquidity option, the
  impact on the given asset
• Two extreme cases for 2 agents (Proba redemption
  20, corr 50)
• Same investors -
  14.6
• Independent investors - 7,9
• Intuitive result at the limit, if the investors
  are random, almost no impact but if the
  investors are shared the risk is huge

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Conclusion

• The HF industry moved from random or positive
  flow of AUM to highly correlated outflows
• It is crucial to quantify and manage the
  investors risk
• Key points
• Better knowledge of investors
• Diversify the strategies
• Dont be short of liquidity option
• Extensions
• Investors redemption / fund performance
  correlation
• Multi period
• Define optimal liquidity of the fund (lock up,
  gates)
• Model the correlation to exogenous factor
  (demography, etc)