19 October 2009
Published in: Market risks
B & H summarizes liquidity premium estimation methods
It is possible to identify liquidity premia (LP) during periods of stress, as well as more benign periods, Barrie and Hibbert has said in a report on liquidity premium estimation. But no single measure offers a simple satisfactory approach to quantification so the challenge is "how to combine the rich information sets discussed in our reports into a robust estimation method."
The new report, Summary of liquidity premium estimation methods, notes that the existence, magnitude and measurability of liquidity premia is the subject of lively debate. "The outcome of the debate will have an impact on the future price of certain financial products and, arguably, the cost of finance for firms using the capital markets," it says. Last month Barrie & Hibbert released a report on Liquidity premium: literature review of theoretical and empirical evidence.
The latest report is not concerned with how to apply an LP estimate to the valuation of insurers' liabilities, the authors stress. "Our focus is on how to estimate benchmark LP and to understand the practical challenges and sensitivities of the estimation approaches and not the comparison of the estimates."
The main body of the report covers three basic approaches: CDS basis, structural model and covered bond spreads. The main findings include:
- Individual estimates vary considerably through time, across economies and compared to each other
- In aggregate, clear patterns emerge from the analysis irrespective of the method used
- Estimated liquidity premia rise over each of the year ends from 2006 to 2008 with a dramatic increase over the last quarter of 2008
- From the end of 2005 until mid 2007, B & H estimates little or no liquidity premium - although during this period bond spreads and market premia were unusually low and far from typical historically
- Liquidity premia estimates generally appear higher for the US dollar than for the Euro or British pound sector
- The Euro estimates derived using the structural model are far lower during the stress periods than both dollar/pound estimates using the same model and other Euro estimates.
The authors note that the report should interest all those concerned with the valuation of assets and liabilities where market prices can be demonstrated in part to be determined by liquidity factors.
The full report can be found at: http://www.barrhibb.com/documents/downloads/Barrie_Hibbert_Summary_of_LP_Methods.pdf