Liquidity in context III

Yesterday I talked about bottom up asset liquidity.  Today I shall continue reviewing the various forms of words which appear in discussions of liquidity.

Liquidity mismatch.

Think of a firm's need for cash as a demand curve.  And its ability to get its hands on cash as a supply curve.  A liquidity mismatch occurs when this set of curves are out of sync.

I shall give two made up examples - an industrial goods manufacturer and a multi-strategy hedge fund.  First the industrial goods company.

The company already has a number of loans, bonds, convertibles outstanding with a number of market participants.  It also has operating cash and holds a number of near-cash securities.  On top of all of this, it has a set of assets and new projects and ongoing projects.  These ongoing projects deliver cash flows into the organisation.  The expected magnitude and timing of these cash-flows is an ongoing estimation problem for the CFO.  It is also a function of the economy generally, of sales, of a broad range of conditions, in other words.

Meanwhile its financial liabilities (those loans and bonds) have a mostly very clear timeline of coupon payments and repayment dates.  It is, of course, part of the CFO's job to manage all of this, but they are operating in an uncertain world.  Projects may bleed, they may fail catastrophically.  Macro-economic disaster might befall the economy.  What resources does the firm have to draw on to meet those more-or-less well known short term cash demands?

Side note.  The need for cash doesn't in general need to be short term, but that is clearly the most pressing end of the timeline.  The immediate future is the period which most rapidly becomes 'now' and 'now' is when a creditor may declare its dissatisfaction with the borrowing firm.

The firm has cash and cash equivalents.  Some of this is considered operating cash - money in the till, to use a shop-keeping analogy.  This cash in a sense needs to be there for the smooth operation of the day to day business of the firm.  But in an emergency this might be considered a pot to be raided.  If the company is prudent, it will also have cash and near cash reserves (certificates of deposit, short term sovereign securities).  A very conservative company might chose to have enough cash in these reserves to pay the next n months, but of course, the n months will pass, and that pot needs to be replenished.  The pot itself is depleted only in exceptional circumstances.  The downside of having too big a pot of cash and cash equivalents is that it is capital sitting earning not much more than a risk free return.  And firms have as a goal the desire to produce a return on equity in excess of the risk free rate.  Otherwise why would an investor invest in a firm in the first place?

So, assuming a new demand for cash materialised, where else might the firm look?  Perhaps new loans or new bonds.  Perhaps a rights issue (a request from current and potential equity investors to give the company cash in return for ultimate fractional ownership in the company).  Perhaps cost savings.  Perhaps the shuttering of certain projects, with concomitant staff reductions.  Perhaps the sale of certain assets in the market - plant, financial securities.  Perhaps the monetisation of some fraction of its asset base.  But as you can imagine, all these options take time, and perhaps some mark down on sale prices - after all, the market might perceive the firm as executing a fire sale, so might be tempted to offer fire-sale prices.

This misalignment of (potentially immediate, potentially short term) demands for cash with (somewhat longer term) supply is what is known as a liquidity mismatch.  

If you think about it, to say that a firm is experiencing a liquidity problem in the first place is to identify a more or less dramatic liquidity mismatch.  So in a sense most liquidity problems are liquidity mismatch problems, and the word liquidity can often be considered as a synonym for a liquidity mismatch problem.

In case 2, the multi-strategy hedge fund, there is a little stub of a management company managing a potentially much larger pool of investments on behalf of investors.  The management firm itself, often a partnership, received equity investment by founding partners, who are said to have committed their cash for the long(-ish)term.  It will have well understood staffing costs and fixed costs.  In some ways, the investment management firm is a bit like 'head office' for a large goods manufacturer, but without the regional factories, offices, large staff, input supply chains, etc.  So the cash flows of the management firm are somewhat clearer.  Also those management firms might have loans but they won't typically be as well developed as with non-financial firms.  For multi-strategy hedge funds, the 'work' happens in the collection of financial assets and liabilities within its fund(s).  These investors in the fund can be flighty, and prime brokers can also adjust the generosity of their leverage terms.  Both of these create the possibility of a liquidity demand.  The fund manager only has the set of assets and liabilities in the fund to supply this needed cash.  So for them asset liquidity modelling and funding liquidity are important, as are a full incorporation of the set of firm constraints on liquidity scenarios.  And where it is unrealistic to fully model the constraints, to approximate them very conservatively.

Despite the seeming differences, both firms managing the possibility of liquidity mismatch are doing the same thing, namely being continually responsive to the balance between demands for cash with sources of cash.

In the next posting I look at the variance (and vol. of vol.) on the demand side of the 'liquidity mismatch' risk which firms of all kinds face.

Liquidity in context - II

Last time I was thinking about funding liquidity and had in my head the multi-strategy hedge fund.  The two primary demands for cash come from prime brokers, who might offer less favourable leverage terms to the hedge fund, which would manifest itself as a demand for more cash to be deposited with them for a given set of holdings on the hedge fund's book at that PB.  The fund would then stump up more cash or gross down their set of holdings.  The second demand is if a significant number and weight of investors in the fund decided, subject to their gates, to redeem their investment.  Th.is is either going to be funded out of the hedge fund's cash (or cash equivalents) bucket or it will make them sell some of their assets and liabilities.  Which brings me on to ...

Asset Liquidity. (Or more strictly speaking, bottom up asset liquidity).

A firm owns a number of units of some security.  The 'asset liquidity' question arises about that holding.  The form of the question is always one of T|CF, C|TF or F|C,T and the source of the answer comes from (1) two facts about the firm and (2) a set of facts about the market for that security.  

The primary firm fact is the position size.  The secondary fact is which collection of constraints are apposite for the liquidation of that asset.  The constraints impose costs (financial, time, fraction) on the unwind.

The market facts are more numerous.  Measuring a market's liquidity is a large subject and the set of data to come to an opinion about its current liquidity is probably asset type and market-specific.  But in general they are statistical reads on the market.

The final piece of the puzzle is how to codify the various statistical reads on the market to produce a liquidity response curve for that market at that time.  Actually, it is not a 2D curve but a 3D surface, with the primary independent variable being F*E, the fraction of the fund's holding of this security being targeted in the liquidity scenario at hand, multiplied by the exposure, E this firm  has to the asset (in simple cases, its quantity).  The surface exists for every exposure point.  In the most general case, the set of curves would extend into negative exposure values for F*E, allowing for asymmetric markets.  The slightly  simpler case is to assume the market is symmetrical and the sign of the exposure is not important.

Whilst in theory all those response curves exist, for any given day, you may only be interested in a single one of them, namely the curve associated with the F*E value in play on that day in your firm.

Usually, either the cost threshold is a parameter of the liquidity run, or the time threshold is given.  In this case, the surface becomes a curve.  E.g. Time(F*E|F=100%, C<1%)  - a safe and compete wind down curve / asset liquidity estimate.  Cost(F*E|F=50%,T=3d) - a drop dead target of 3d to reduce the holding size by half.  Both of these are asset liquidity estimates.

Think of the cost and time curves both in terms of the absolute cost (EUR) or time (days) for a position of size F*E to be unwound, in which case this is an upward sloping convex curve of some sort or another; or think of the cost as a cost per unit, in which case its convexity is fully explained by the expect saturation cost associated with bringing a larger and larger fraction to market.  Very liquid markets have a flat per-unit response curve both for time and cost.

I will call these per-unit response curves lower case $t_m(F_s \times E_f|F_s,C_s,n_s)$ where $m$ stands for a market object, $s$ being a liquidity scenario parameter and $f$ being a fact of the firm and $n_f$ being the collection of firm unwind constraints.  Likewise the second of the possible asset liquidity measures is $c_m(F_s \times E_f|F_s,T_s,n_s)$.

Liquidity in context - I

In this posting I'd like to talk about a couple of liquidity related phrases and their meaning.  

First of all the word 'liquidity' itself.  Someone at some point in history decided that describing the degree to which an entity is able to meet its obligations through access to cash when required required a metaphor of a liquid.  If flows everywhere, which I think must be the point originally.  It is from this starting point that you get a liquidation activity, which is when non-liquid assets get disposed of (sold) for cash.  The word liquidation now also carries a strong separate sense, meaning to have its structure (solidity) destroyed (melted).  I think this is secondary.  From bankruptcy terminology, the word has entered common parlance to mean to end or terminate something or someone.

Liquidity risk.

This term, in contradistinction to market risk, credit risk, macro-economic risk (pan-market risk), etc., is an umbrella term describing the measurement and management of the risk that an entity (typically a firm) cannot meet one or more obligations (financial obligations).  As such it is a species of financial risk,  as opposed to non-financial risk.  Cash is a financial asset after all, so no surprise there.

Funding liquidity.

Organisations fund their operations through equity investment in the firm, financial markets debt, bank loans, and various forms of credit or leverage agreement.  Each potential provider of this funding is making an ongoing endless decision about the firm with respect to how worried they are about getting their investment back.  It is this ongoing endless decision which is one of the causes of funding liquidity risk.  Take, for example, a modern hedge fund.  It may have received cash from equity investors in the firm.  This cash received is used to fund projects within the firm.  The resulting equity represents a liability to the hedge fund.  It owes the equity investors.  How much they owe is a function of how the world values that equity component.  Is it work only as much as the original capital investment (i.e. the book cost, in accounting terms) or has the firm managed to grow its enterprise value and hence does the world now value the equity stake higher?  How ongoing is the re-appraisal of the value of the firm's equity?  This can vary a lot.  Publicly listed companies have active secondary markets and hence the current value of the equity is continuously evaluated.  Private firms (as a majority of hedge funds are) get their equity marked much less frequently.  Also, in one sense the final owner of the equity is irrelevant for these purposes.  Whereas equity owners may (and do) decide whether to sell their stake on the secondary market or privately all the time, the principal agents of the firm still regard this liability as ever-present.  In the general case, normal transactions in the secondary market may provide liquidity to the owners of the equity but the company itself has long since used the original capital for various purposes.  In abstract, the  equity owner owns this asset forever (even though their identity changes from secondary market trade to secondary market trade).

Next come bank loans.  Again, cash came in to the fund and a series of obligations got created.  These obligations are utterly different to the firm's obligation to the equity owner.  The loan obligation includes a lot more certainty and specificity - interest payments need to be made on certain dates, the loan has a maturity which is well understood.    Firms use loans on an ongoing basis, so there's always a chance that the loan providers worsen the terms of the loan or fail to consider rolling the loan.  This is a potential cause of funding liquidity risk.  Similarly for all forms of capital market bond - the lender is a collection of market participants, but otherwise the structure and risks are the same.  Next a hedge fund might get leverage from prime brokers.  This amounts to a greater or lesser spending capacity for the hedge fund, at a fee for the prime broker.  Finally the hedge fund itself has a number of investors in the fund vehicle itself.  These investors can be much more flighty and might decide on an ongoing basis to either keep their money in that fund, or redeem their investment, subject to an often complex set of company-imposed withdrawn constraints often called 'gates'.

Funding liquidity risk can be instigated by the firm's loan creditors, the fixed income market in its aggregate willingness to lend the firm new money on an ongoing basis, its investors and even by secondary effects of its equity holders, insofar as selling pressure on the firm's equity may feed back negatively into direct funding sources.  Funding liquidity risk is ultimately caused by one of two drivers - first, the set of funders collectively decide that the firm is less worthy of funding and second the set of funders either individually or collectively themselves become stressed and are caused to reduce the level of their funding to that (and potentially other) firms.

So much for the causes, the mechanism is also two parted.  Firms have ongoing funding requirements.  The degree to which this is lumpy or smooth is a whole world in itself.  But if a firm experiences a funding liquidity episode, then the funders singly or collectively might change or exercise clauses in the current set of in play funding transactions to make the level of funding reduce, or secondly they might worsen terms of new funding transactions with the firm and in the limit completely refuse to offer any additional new funding.  Loans, bonds and converts offer a degree of stability in their prospectuses which allows for funding stability.  Prime brokers can much more rapidly change the terms of their implicit funding pretty much overnight, and hence are a potential cause of much more immediate and unpredictable funding liquidity risk for a hedge fund.  Hedge fund don't often have loans or bonds though, so their primary funding liquidity risk vectors are investor and prime broker flightiness.  So when it comes to estimating the nature of the funding obligation (how much needs to be liquidated and by when or at what cost) then modelling investor gates and the volatility of PB leverage will need to be examined to establish the magnitudes of liquidity risks in various scenarios.