PORTFOLIO LIQUIDITY MANAGEMENT WITH EXPECTED SHORTFALL CONSTRAINT

Abstract In a standard approach to portfolio valuation, it is assumed that market is perfectly liquid, so assets in the portfolio have unique prices. In reality, however, this does not seem to be true. Liquidity deterioration in the market may have an impact on the asset values. Also, the liquidity policy, which the portfolio is restricted by, can influence on its value. In this paper, we describe and analyze the relationship between the portfolio value and the liquidity policy. When quantifying the portfolio value, coherent portfolio risk measure (CPRM) is employed. In the portfolio valuation model, the Power-Law marginal supply-demand curve (MSDC) is used to deal with the different level of liquidity of the constituents. The portfolio value is assessed based on the liquidity constraints includes capital requirement, minimum weight and portfolio Expected Shortfall (ES) value. These restrictions affect, to a varying degree, the liquidation of illiquid and high volatility assets. We found that as liquidity policy becomes stricter with the portfolio ES constraint, the liquidation cost increases significantly. Also, the liquidation cost increased according to the portfolio ES liquidity policy is particularly pronounced as the size of the portfolio become larger and the trade duration becomes shorter.