What are the main components of market liquidity risk?

Question

AcadiFi · Accepted Answer

Market liquidity risk decomposes into four measurable dimensions, often called the CGFS framework:

1. **Tightness** — the cost of executing a small trade near mid, typically measured by the bid-ask spread. In calm markets Brindan Capital might see 2-bp spreads on liquid equities; in March 2020 stress these widened to 20+ bps.

2. **Depth** — the quantity available at the best bid-ask without moving the price. Limit order book depth at the top-of-book is measured in shares or notional. Shallow depth means even modest orders cause slippage.

3. **Resilience** — the speed at which prices revert after a large trade absorbs liquidity. High resilience means the book refills quickly; low resilience means prices remain dislocated for minutes or hours.

4. **Immediacy** — the time required to execute a desired trade. Related to resilience but focuses on execution latency rather than price recovery.

```mermaid
flowchart TD
    A[Market Liquidity] --> B[Tightness: spread]
    A --> C[Depth: size at mid]
    A --> D[Resilience: recovery speed]
    A --> E[Immediacy: execution time]
    B --> F[BDSS LVaR]
    C --> G[Market impact model]
    D --> H[Volume-weighted mean reversion]
    E --> I[Time-to-fill metrics]
```

In stress events, all four dimensions deteriorate jointly. Corvera Risk Analytics tracks a composite liquidity score blending spread, depth, and volume-weighted resilience. FRM candidates should connect these dimensions to specific metrics: Amihud illiquidity for depth, Kyle's lambda for impact, and autoregressive return models for resilience. Understanding the decomposition helps design proper liquidity stress tests rather than generic spread shocks.

What are the main components of market liquidity risk?

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