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Abstract
This article sets forth the proposition that liquidity risk may be optimized in an attempt to forestall or minimize the impact of a liquidity crisis. For a generic (but typical) endowment asset allocation, the authors find that liquidity levels between 6% and 14% are optimal, all other things equal, because 95% of the time, an allocation in this range would obviate situations in which a portfolio’s payout rate exceeds its liquidity pool. The framework also provides insights for tail-risk events involving a particularly severe liquidity crisis. For a generic endowment portfolio, the analysis indicates that in order to reduce the severity of a liquidity crisis to zero (i.e., eliminate risk completely), the allocation to fixed income would have to be around 35% (close to seven times the payout rate of 5%). Such an allocation would entail a very significant opportunity cost in terms of forgone returns based solely on a desire to mitigate extreme liquidity events (the proverbial “100-year flood”). In the authors’ view, reducing the likelihood of a liquidity crisis to below 5%, may be undesirable for all but the most risk-averse and least returnsensitive endowments.
Footnotes
Disclaimer The views expressed in this article are entirely those of the authors and do not necessarily reflect those of JP Morgan. The authors alone are responsible for any errors and/or omissions. This article is an updated version of a standalone JPMorgan publication dated June 2010.
- Copyright 2011 J.P.Morgan Chase & Co. All rights reserved. Not to be reproduced or redistributed without permission.
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