risk, how it is defined and how a portfolio manager handles the risk of owning specific

types of positions. Additionally we will discuss the advantages and disadvantages of employing

liquidity management. Managing portfolio risk beyond directional

and non-directional risks attempts to eliminate the risk that are based on the liquidity

of assets within the portfolio. Liquidity risk includes the ability of a portfolio manager

to unwind a position and generate cash in a timely and efficient manner. Historically,

there have been a number of events in the recent past that have created the need to

analyze the liquidity and transparency of a portfolio. For example, in 2008, even the

very liquid Eurodollar contracts, which allow traders to hedge Libor, where relatively illiquid,

due to the financial crisis and the inability of banks to lend to one another.

Liquid products such as government bonds, large cap equities and currencies, have relatively

tight bid offer spreads, which allow an investor to enter and exit a position without significant

slippage. A bid-off spread is the different between where market markers will purchase

a financial instrument, which is called the bid, and where market makers will sell a financial

product, which is called the offer. These types of markets are relatively transparent,

and finding liquid price action is readily available. Certain types of assets, such as real-estate

or loans, are less liquid and are more opaque than liquid markets. Transactions on these

types of assets can be few and far between, and the bid offer spread, can be very wide.

Non-liquid products are usually over the counter products which are traded under guidelines

that are governed by the market participants themselves. For example, many financial instruments

that are over the counter instruments are governed by ISDA, the International Swaps

Dealers Association. The guidelines give some semblance to the market environment. Products

can range from interest rate swaps, which allow companies to hedge against specific

interest rate exposures to exotic options that are used to make sophisticated bets.

Most over the counter products are traded by market makers which are generally banks,

investment banks, and large hedge funds. The market can exist through exchanges such as

the Chicago Mercantile Exchange or the Intercontinental Exchange, or a broker market that can be online

or over the phone. Each position within a portfolio has specific

liquidity and a cost associated with it to turn it into cash. For example, a 5-year natural

gas swap will have a larger bid/offer spread than shares of a large liquid stock such as

Microsoft. When evaluating the positions in a portfolio,

a portfolio manager should create a risk profile in which reserves are calculated to accommodate

a positions. Evaluating historical bid/offer spread will allow the portfolio manager to

create a "market risk reserve" in which capital is set aside when a position is entered, and

released when a position is liquidated. Managing liquidity risk is an important concept

that should be reviewed especially for any opaque portfolio. A historical market risk

reserve is a formula that evaluates historical bid offer spreads of specific assets to generate

a pool of capital that can be removed from the portfolio profit and loss. An example

of how this works is as follows: Let's assume a portfolio manager purchases

and over the counter product that has a historical bid offer spread that is wide. A portfolio

manager can create a market reserve where a specific amount of capital is moved out

of the portfolio to account for the lack of liquidity. This reserve is added back to the

portfolio when the position is closed out. The concept is similar to creating a margin

account for over the counter products. Instead of posting initial margin to a futures broker,

the portfolio manager creates an artificial margin account which insulates a portfolio

manager from large slippage created by opaque products.

The advantage of managing liquidity risk is that is employs some analytics on products

that create losses when the portfolio manager exits a position. The more volatile the market

environment, the more difficult it can be to exit illiquid positions. The disadvantage

is that income is set aside to incorporate this type of risk management.