Chapter 24: Liquidity Risk
24.13.
Discuss whether hedge funds are good or bad for the liquidity of markets.
As discussed in the chapter, the major source of liquidity risk is liquidity black holes where most
market participants want to be on the same side of the market at the same time. Hedge funds are
However, hedge funds are themselves big players in some markets. Hedge funds tend to follow
similar trading strategies to each other. As a result, they respond in the same way to market
24.14.
Suppose that a trader has bought some illiquid shares. In particular, the trader has 100 shares of
A, which is bid $50 and offer $60, and 200 shares of B, which is bid $25 offer $35. What are the
proportional bid–offer spreads? What is the impact of the high bid–offer spreads on the amount
it would cost the trader to unwind the portfolio. If the bid–offer spreads are normally distributed
with mean $10 and standard deviation $3, what is the 99% worst-case cost of unwinding in the
future as a percentage of the value of the portfolio?
The proportional bid-offer spreads for share A and B are 10/55 =0.1818 and 10/30=0.3333. The
24.15. (Spreadsheet Provided)
A trader wishes to unwind a position of 200,000 units in an asset over eight days. The dollar
bid–offer spread, as a function of daily trading volume q, is a + b cq where a = 0.2, b = 0.15 and
c = 0.1 and q is measured in thousands. The standard deviation of the price change per day is
$1.50. What is the optimal trading strategy for minimizing the 99% confidence level for the
costs? What is the average time the trader waits before selling? How does this average time
change as the confidence level changes?
The spreadsheet shows that the optimal trading strategy is to trade 33.4, 31.1, 28.7, 26.2, 23.5,