liquidity premium
- Thread starter babu
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Hi babu,
Regarding "liquidity premium in terms of commodities and how it is calculated," I don't know what exactly what that means and it's not (to my knowledge) in the cirriculum.
liquidity premium suggests to me the liquidity preference theory. See http://en.wikipedia.org/wiki/Yield_curve#Liquidity_preference_theory
...offered to explain upward sloping term structure
many of our (FRM assigned) models do not explicitly factor in liquidity. For example, cost of carry does not have a factor for liquidity. Not being in the model, i refer to it a technical (non fundamental) factor, like supply/demand. I could argue, but i am not sure i have support for this, that the convenience yield reflects liquidity; so indirectly i could imagine the convenience yield impounds liquidity...
but otherwise, I would say, in general, liquidity is "added on" to our models; e.g, VaR becomes liquidity-adjusted by increasing VaR by one-half the spread. Similarly, collateral assets are "haircuted" (reduced) to reflect less liquidity (it may be worth $100 but if i can't be sure i can sell it, maybe i should haircut by 10%).
Add to this: liquidity has different definitions: we care about funding liquidity risk versus market liquidity risk.
You might argue, again i don't have support for this currently, that the convexity adjustment in comparing a (liquid) futures price to an (illiquid) forward price is a way of incorporating liquidity. Then, as i think out loud, because this topic does not "fit in a box", I might argue that (i) the convenience yield indirectly factors liquidity and (ii) the convexity adjustment might start to size liquidity (future vs forward) but beyond that, I'd fall back on basic finance and say that it typically gets included by a some (haircut) reduction in the price, which is another way of saying, a higher rate to reflect the additional liquidity risk. But the thing about liquidity risk is, it's hard to parse out from other factors.
David
Regarding "liquidity premium in terms of commodities and how it is calculated," I don't know what exactly what that means and it's not (to my knowledge) in the cirriculum.
liquidity premium suggests to me the liquidity preference theory. See http://en.wikipedia.org/wiki/Yield_curve#Liquidity_preference_theory
...offered to explain upward sloping term structure
many of our (FRM assigned) models do not explicitly factor in liquidity. For example, cost of carry does not have a factor for liquidity. Not being in the model, i refer to it a technical (non fundamental) factor, like supply/demand. I could argue, but i am not sure i have support for this, that the convenience yield reflects liquidity; so indirectly i could imagine the convenience yield impounds liquidity...
but otherwise, I would say, in general, liquidity is "added on" to our models; e.g, VaR becomes liquidity-adjusted by increasing VaR by one-half the spread. Similarly, collateral assets are "haircuted" (reduced) to reflect less liquidity (it may be worth $100 but if i can't be sure i can sell it, maybe i should haircut by 10%).
Add to this: liquidity has different definitions: we care about funding liquidity risk versus market liquidity risk.
You might argue, again i don't have support for this currently, that the convexity adjustment in comparing a (liquid) futures price to an (illiquid) forward price is a way of incorporating liquidity. Then, as i think out loud, because this topic does not "fit in a box", I might argue that (i) the convenience yield indirectly factors liquidity and (ii) the convexity adjustment might start to size liquidity (future vs forward) but beyond that, I'd fall back on basic finance and say that it typically gets included by a some (haircut) reduction in the price, which is another way of saying, a higher rate to reflect the additional liquidity risk. But the thing about liquidity risk is, it's hard to parse out from other factors.
David
babu1,
It's frankly more of a "punt" on my part (I don't have commodity model--ie, cost of carry models--that explicitly incorporate liquidity; although I would expect them to exist, I am just not awares)
In our study of cost of carry F= Spot*EXP[( financing rate + storage cost - explicit yield - convenience yield)]
and the convenience yield, in addition to incorporating the "intangible" benefits of ownership (e.g., the real option benefit of, say, holding oil) also tends to include anything else not in the model. As McDonald rightly says: it is a bit tautological, as the convenience yield can be used to justify any forward curve. So, I was really going in that direction: offering the convenience yield, or perhaps the combination of storgage - convenience yield, as joint factors which *might* incorporate a liquidity view...but it is theorizing only...it might be better to Google-find actual research that explictly models liquidity. Thanks, David
It's frankly more of a "punt" on my part (I don't have commodity model--ie, cost of carry models--that explicitly incorporate liquidity; although I would expect them to exist, I am just not awares)
In our study of cost of carry F= Spot*EXP[( financing rate + storage cost - explicit yield - convenience yield)]
and the convenience yield, in addition to incorporating the "intangible" benefits of ownership (e.g., the real option benefit of, say, holding oil) also tends to include anything else not in the model. As McDonald rightly says: it is a bit tautological, as the convenience yield can be used to justify any forward curve. So, I was really going in that direction: offering the convenience yield, or perhaps the combination of storgage - convenience yield, as joint factors which *might* incorporate a liquidity view...but it is theorizing only...it might be better to Google-find actual research that explictly models liquidity. Thanks, David
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