Cornell Hosts NSF-Sponsored Liquidity Risk Conference

The mathematical analysis of liquidity risk began at Cornell, which was the location of a recent conference on the topic. Liquidity risk is the risk that an asset cannot be readily sold, despite having value,  due to market conditions. Some examples: the sell order might be too large to immediately attract a counter party to buy; the asset may trade only infrequently so that the number of shares available to trade may be limited at a particular time; or a market panic might arise, during which it is hard to find buyers.   

Liquidity risk issues have reached home owners who wish to sell in today's market but find too few prospective buyers who can get mortgage loans. There has been a growth in financial instruments whose value derives from these mortgage loans. As a result the housing crisis has spread to the banks and investment houses with major positions in these derivatives, most notably Bear Stearns, whose sudden collapse resulted from what amounts to a classic 'run on a bank.' More recently government intervention was required to help  the Federal National Mortgage Association (known from its acronym as "Fannie Mae") and Freddie Mac (formerly the Federal Home Loan Mortgage Corporation) avoid a similar fate.

Liquidity risk can be analyzed mathematically using advanced constructs in probability theory and stochastic processes. According to ORIE professor Philip Protter, academics break the overall concept of financial risk into five rubrics: market risk, credit risk, model risk, operational risk and liquidity risk. Of these five, until 2004 only the first two had been studied extensively using such mathematical models. Protter notes that the 'serious mathematical study of liquidity risk' began in that year,  when he, ORIE and Johnson Graduate School of Management professor Robert Jarrow and their student Umut Çetin developed a seminal paper on the subject. (Çetin is now a lecturer in statistics at the London School of Economics). 

In the past four years the field has exploded with activity. To mark this development, at the end of June 2008 about 50 researchers came from five countries to attend a Liquidity Risk meeting at Cornell University. According to Protter, the conference organizer, "it was a huge success, as far as I can tell."  Deniz Sezer, an ORIE Ph.D. alumna who is currently a post-doctoral fellow in Mathematics and Statistics at York University in Canada, said that the conference "gave me a good exposure to both theoretical and practical aspects" of the liquidity problem.  

In addition to Protter, ORIE faculty participants included Professors Robert Jarrow, Alexander Schied and Stefan Weber.  The conference was made possible by a grant from the National Science Foundation.

The topicality of the meeting is indicated by the titles of some of talks: : 

• "Distressed Debt Prices and Recovery Rate Estimation," by Robert Jarrow (with X. Guo and H. Lin)
• "Liquidity Risk and Trade Impact" by Cornell graduate student Alexandre Roch
• "The Cost of Illiquidity and Its Effects on Hedging" by Chris Rogers of Cambridge University (with S. Singh) 
• "Case Studies in Bond Market Illiquidity - Explaining Liquidity Anomalies" by Wesley Phoa of The Capital Group 
• "Hard-to-Borrows, Volatility and Bubble Dynamics: A Challenge to Jarrow & Protter?" by Mike Lipkin of Katam Inc. and Columbia University
• "Optimal Portfolio Liquidation" by Alexander Scheid

Sezer commented that the "the impact of liquidity risk on financial markets needs to be better understood and predicted." She said this point was best illustrated by the case study presented by Phoa, "which conluded that a certain major crisis in the bond market was caused by market illiquidity."

In addition to the current Cornell faculty members and several current graduate students, several recent Cornell graduates and post-doctoral fellows attended the meeting, including Sezer, Kazuhiro Shimbo and Sasha Stoikov.  Shimbo is with Mizuho Alternative Investments, LLC, and Stoikov is a visiting professor of Industrial Engineering and Operations Research at Columbia University. Sezer and Stoikov delivered papers at the meeting.