Liquidity-Adjusted Value-at-Risk for Portfolios of Assets

Over the past decade, Value-at-Risk (VaR) has become the most prevalent technique for measuring maximum portfolio losses over a specific time horizon at a given probability. However, traditional VaR models do not account for liquidity so that they underestimate the magnitude of overall risks and misrepresent the reserved capital for financial institutions. This paper aims to incorporate the liquidity component into the traditional VaR model to demonstrate the importance of liquidity when managing market risk. After reviewing a number of studies, we decided to apply the Liquidity-Adjusted Value-at-Risk model developed by Bangia, Diebold, Schuermann and Stroughair (1998). We first use this model to estimate the Liquidity-Adjusted VaR (LAVaR) for a single asset. We later extend this model to get a general form of LAVaR for portfolios of N assets by adding the covariance between relative spreads of any two assets.