What are the best practices for managing liquidation risk in a portfolio?

1 Know your liquidity needs

The first step to managing liquidation risk is to understand your liquidity needs, which depend on your investment objectives, time horizon, and cash flow requirements. You should have a clear plan for how much cash you need to keep on hand, how much you can invest in illiquid assets, and how much you can tolerate volatility and uncertainty. You should also consider the potential impact of market conditions, such as interest rates, inflation, and economic cycles, on your liquidity needs.

4 Use appropriate liquidity measures

The fourth step to managing liquidation risk is to use appropriate liquidity measures to assess the liquidity of your portfolio and its components. Different measures, such as market liquidity, funding liquidity, and portfolio liquidity, capture different aspects of liquidity risk and should be tailored to the characteristics and objectives of your portfolio. Common liquidity measures include market liquidity, such as trading volume, bid-ask spread, price impact, and market depth; funding liquidity, such as margin requirements, collateral value, borrowing rates, and credit lines; and portfolio liquidity, such as liquidity ratio, turnover ratio, liquidation value, and liquidation time. It is important to consider these measures in order to properly manage the risk associated with liquidating a portfolio or portion thereof.

5 Manage your liquidity risk exposure

Managing liquidity risk exposure is the fifth step to managing liquidation risk. To do this, you can make use of various tools and techniques, such as cash management, liquidity buffer, liquidity contingency plan, liquidity risk transfer, and liquidity risk hedging. Cash management involves optimizing your cash balance, forecasting cash flow, budgeting, and allocating cash. A liquidity buffer is an amount of cash or liquid assets that you hold in your portfolio to meet your expected and unexpected needs and take advantage of market opportunities. A liquidity contingency plan is a plan you prepare in advance to deal with crises, such as identifying triggers and potential sources for emergency funding. Liquidity risk transfer is the process of transferring your risk to another party who can provide services for a fee or spread. Finally, liquidity risk hedging involves using derivatives or other instruments like futures, options, swaps, or ETFs to hedge your risk by creating synthetic liquidity, locking in prices, or reducing exposure.

6 Review your liquidity risk management

The sixth step to managing liquidation risk is to review your liquidity risk management periodically, and update it as needed. You should evaluate the effectiveness and efficiency of your liquidity risk management, by measuring and reporting your liquidity risk performance, such as liquidity risk indicators, metrics, and limits. You should also conduct stress tests and scenario analyses, to assess the impact of extreme and adverse market events on your liquidity risk. You should identify and address any gaps or weaknesses in your liquidity risk management, and implement any improvements or changes that are necessary.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?