A Fully Integrated Liquidity Market Risk Model

Going beyond the simple bid—ask spread overlay for a particular value at risk, this paper introduces a framework that integrates liquidity risk, funding risk, and market risk. We overlay a whole distribution of liquidity uncertainty on future market risk scenarios and we allow the liquidity uncertainty to vary from one scenario to another, depending on the liquidation or funding policy implemented. The result is one easy-to-interpret, easy-to-implement formula for the total liquidity-plus-market-risk profit and loss distribution. A revisited version of this paper was published in the November/December 2012 issue of the Financial Analysts Journal.