Hedging Liquidity Risk

Abstract

The financial markets have successfully established hedging instruments to protect against market risk, interest rate risk, currency risk, commodity risk and credit risk. The classic work in option-pricing by Black & Scholes [1973], and Merton [1973] helped mitigate equity risk through the prudent use of equity options. In the past three decades, derivatives in interest rates, foreign exchange, weather, and real estate have all grown in popularity. Each of these instruments allows for the isolation of an element of risk, and the transfer of this risk to a willing market participant. Recently introduced derivatives protect against adverse weather and real estate movement. Liquidity risk however, although well known, is not directly hedged, since liquidity derivatives do not yet exist. This article introduces several liquidity derivatives, which can protect against liquidity and/or return risk. Applications and elementary pricing algorithms are provided. Proposals of areas of further research are also suggested.