Liquidity commonality and risk management
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Date
2012-03-07
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Abstract
We propose to model the joint distribution of bid-ask spreads and log returns
of a stock portfolio by using Autoregressive Conditional Double Poisson and GARCH
processes for the marginals and vine copulas for the dependence structure. By estimating
the joint multivariate distribution of both returns and bid-ask spreads from intraday data,
we incorporate the measurement of commonalities in liquidity and comovements of stocks
and bid-ask spreads into the forecasting of three types of liquidity-adjusted Value-at-Risk
(L-IVaR). In a preliminary analysis, we document strong extreme comovements in liquidity
and strong tail dependence between bid-ask spreads and log returns across the firms in our
sample thus motivating our use of a vine copula model. Furthermore, the backtesting results
for the L-IVaR of a portfolio consisting of five stocks listed on the NASDAQ show that the
proposed models perform well in forecasting liquidity-adjusted intraday portfolio profits and
losses.
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Keywords
commonality, liquidity, liquidity-adjusted intraday Value-at- Risk, vine copulas