Market liquidity risk and its incorporation into value at risk

Over the past few years, the Value at Risk indicator (VaR) has evolved, without doubt, into the most frequently used comprehensive tool for assessment of potential losses caused by adverse changes in market rates. However, the common models used for VaR assessment are based only on mid prices and do not take into account the existence of time-varying bid-ask spreads. In addition, they assume that any amount of instruments can be sold almost immediately without an adverse impact on prices. Thus, they focus only on pure market risks without taking into account the market liquidity. As a consequence, they underestimate the total risk. This paper focuses on the importance of market liquidity and describes ways to integrate it into the VaR calculation.