Bond Liquidity Risk and Prudent Valuation
Summary
The document distinguishes two meanings of liquidity risk. One concerns whether assets can be sold or repoed quickly enough to meet cash obligations. The other is the price impact or discount that may arise when an investor must sell an illiquid bond, which can make it riskier than a more liquid bond with the same return.
For measuring this second concern, the answer points toward prudent valuation: compare a bond’s fair yield under normal market conditions with a higher yield reflecting a forced or fire-sale sale. This offers a way to represent liquidity-related valuation uncertainty, rather than simply adding a normalized bid-ask spread term to return volatility. The response recommends a conceptual direction and references further literature and regulatory guidance, but provides no formula, portfolio implementation, or empirical test. Prudent yields are scenario-dependent and should not be treated as a direct substitute for standard volatility without a clear measurement objective.
Key ideas
- Liquidity risk can refer to cash-raising constraints or to losses from selling assets under stressed conditions.
- Illiquid bonds may warrant a larger valuation adjustment even when their observed returns match those of liquid bonds.
- Prudent valuation compares normal-market fair yields with yields under fire-sale conditions.
- The document suggests a valuation framework but does not specify a volatility adjustment or test a portfolio method.
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Full text
# Taking into account liquidity risks when calculating volatility # Taking into account liquidity risks when calculating volatility I am looking at bonds where some are more liquid than others, in that some bonds have a much higher volume than others. If I am holding a bond X with more liquidity than bond Y, but X and Y receive the same return, I would like a way of showing the “risk” of holding bond Y was higher. Currently the way I would like to do this is incorporate into the bond volatility somehow. Are there any books or literature on this, or has this been done elsewhere? This would allow me to say something about the risk adjusted return for the bonds which are illiquid - which is what I am looking to do. It seems like theirs is a lot of talk about liquidity risk but not a lot of literature in how to take it into account quantitatively when analysing a portfolio systematically. A basic metric I can think of is using some sort of normalized measure of the bid ask spread, and penalising the volatility by an additional term to account for the bid ask spread width. Thanks in advance for your suggestions! ## Answer by Dimitri Vulis (score 1) https://quant.stackexchange.com/a/81192 The term liquidity risk is used to mean two different things. There are many books and web pages about liquidity risk in the sense of asset liability management, over-simplifying - the fear that while solvent, you have assets that you can't sell or repo fast enough to pay the bills. I think you should be looking for "prudent valuation" (PruVal) for bonds, i.e. the difference between the fair yield that you'd get selling your bonds under normal market conditions versus the prudent yield, higher than fair, that you'd get selling your bonds in the secondary market under "fire sale" conditions. A good paper is https://pages.stern.nyu.edu/~adamodar/pdfiles/papers/liquidity.pdf . Also there is some EU regulatory and supervisory guidance, e.g. https://www.eba.europa.eu/sites/default/files/document_library/Publications/Draft%20Technical%20Standards/2020/RTS/882753/EBA-RTS-2020-04%20Amending%20RTS%20on%20Prudent%20Valuation.pdf
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