Reserve Bank of India Occasional Papers Vol. 25, No. 1, 2 and 3, Summer, Monsoon and Winter 2004

Liquidity Adjustment in Value at Risk (VaR) Model: Evidence from the Indian Debt Market
Sunando Roy*
Conventional Value at Risk models are severely constrained while dealing with liquidity risk. This inevitably leads to an underestimation of overall risk and consequently misapplication of capital for the safety of financial institutions. Standard Value at Risk (VaR) model assumes that any quantity of securities can be traded without influencing market prices. In reality, most markets are less than perfectly liquid and many securities cannot be traded with ease in markets. This is especially true for emerging market economies where the process of financial sector reform and deepening is currently taking place. Despite episodic evidences of liquidity crisis in the Indian financial markets, risks associated with market illiquidity have not been effectively incorporated into the VaR models. In the face of sudden and persisting off-market prices of some of the securities in their portfolio, the Indian financial organizations often find it difficult to offload these securities without booking significant trading losses. As a consequence, several securities exhibit very low levels of turnover in the secondary segment of the debt market. Also, in most cases, measures of market risk fail to capture the costs of carrying illiquid assets in their portfolio. This becomes a constraining factor for market growth. In this context, the paper attempts to construct a Liquidity adjusted VaR model (L-VaR model) that incorporates liquidity risk in Value at Risk models. The paper tests the performance of L-VaR model vis-a-vis existing VaR models and finds that in the Indian context, the liquidity risk is an important component of the aggregate risks absorbed by the financial institutions.