Market Liquidity

Measuring liquidity risk can be separated into two main categories, measures of liquidity risk itself and measures of asset liquidity. These two main parts are than divided into two and four sub-categories respectively. Banks and other financial intermediaries often measure their liquidity risk using either the liquidity gap or the liquidity risk elasticity techniques. On the other hand measures of asset liquidity include bid-offer spread, market depth, immediacy, and resilience.
Measures of liquidity risk
Liquidity gap
The liquidity gap is defined as the net liquid assets of a firm. It is a measure of the variance between a bank’s total liquid assets and the total amount of liabilities. This liquidity mismatch is one way of measuring a bank’s financial risk. Measuring these liquidity gaps help assesses the financial health of institutions. The formula used in calculating this liquidity gap is very simple, liquid assets minus liquid liabilities. A positive gap means that an institution has liquid assets left over once all the liabilities have been paid, while a negative gap shows that the bank is getting less income than the liabilities assumed. Liquidity gaps are mostly used banks to assign interest rates to loans based on the amount of risk perceived in lending money to a certain institution.
Liquidity risk elasticity
Liquidity risk elasticity can be measured as the net change of assets over funded liabilities that occur when the liquidity premium on the bank’s marginal funding cost rises by a small amount. In simple terms the equation used to calculate the liquidity risk elasticity is, LRE = change in assets over marginal funding minus the funded portion times the change in liabilities over marginal funding. Since the denominator is a spread, a small increase in the funding cost to the firm would correspond to a change to the firm’s net liquid assets. The greater this sensitivity of net liquid assets to changes in funding costs, the greater the liquidity