"Liquidity Insurance", posted March 3 on AllAboutAlpha.com

Konstantin Danilov, CAIA
Bank of America

Liquidity is a topic that is brought up often in the wake of a financial crisis. The crash of 1987, LTCM, Amaranth, and the current sub-prime crisis are all examples of the devastating impact of illiquidity.  Unfortunately, it is a factor that eludes the most risk management tools and risk/return models in modern financial theory.  For example, Value-at-Risk (VAR) and "portfolio insurance" largely ignored illiquidity (or "assumed" it away) and we were left with the consequences. 

However, illiquidity in a less extreme form affects market participants on a daily basis in the form of everyday transaction costs.  Returns on a stock position that exist on paper can quickly disappear when a manager attempts to sell it to capture a profit, especially if the stock is thinly traded.

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