This week’s 30-minute movie reviews model & liquidity risk(readings IV.1, IV.3 & IV.7). Holding sufficient cash on thebalance sheet is the CFO’s concern and that’s funding liquidity risk
. Worrying about asset value deterioration is market liquidity risk:
Thefactors that impact an asset’s liquidation cost include time horizon,asset type, fungibility (i.e., how easy can we sell or replace theasset?), market microstructure and the bid-ask spread:
KevinDowd divides models into three types: fundamental, descriptive, andstatistical. A key theme in the Dowd reading is epistemological: whenwe apply a model, we cannot escape making an assumption
. We may choose between assumption trade-offs, but no model can escape reliance on some a priori, unverified
assumption. The point is to at least be aware of your assumptions!
TheRebonato reading is short but non-trivial. Rebonato’s definition ofmodel risk: the risk of a significant difference between themark-to-market model value (i.e., what value does the model give us,currently?) and the traded price (what price is the market giving?):