A Research On Liquidity Risk Management Of Chinese Open-ended Funds Based On LVaR Model

VaR estimates the likelihood of a portfolio loss caused by normal market movements over a given period of time. With the simplest form, VaR facilitates managers and regulators in risk management and monitoring by combining the potential losses and possible probability of combination of known portfolio into a single number and analyzing results of multiple risks. Favored by international financial regulatory agencies, VaR risk management tool and the new improved VaR becomes an international standard for risk management and is brought into application of risk management in the BaselⅡ. Applying so many hypothesizes and ignoring measurement of liquidity risks, traditional VaR underestimates the risks the market faced. So it is theoretical and practical to come up with LVaR model and be an improved risk management tool by bringing in the liquidity risks under the traditional form.With the growing concern of liquidity risk, it has become a very important and popular issue to measure liquidity risk with LVaR model. Most scholars analyze LVaR model based on bid-ask spread and optimal trading strategy method of price shock and adjusting asset positions realizable deadline. Therefore, one of the main purposes of this paper is to construct an appropriate LVaR with the actual situation of China’s securities market and try to draw some rich theoretical and practical significant conclusions.Chinese security investment funds industry has developed rapidly in recent years. Especially open-ended funds develop rapidly and become main development direction of Chinese funds industry. In the financial crisis in 2008, Chinese securities market drops down dramatically. And the liquidity risk of open-ended funds stands out. The liquidity risk of open-ended fund is that because of the uncertainty of the time and quantity of redemption, the fund assets held causes the uncertainty and suffers great financial losses in the liquidity process. The origin of the liquidity risk of open-ended fund is the contradiction between asset profitability and liquidity. Therefore how to measure and control the liquidity risk of open-ended fund is the focus of fund managers and investors. If the specific value of the liquidity risk of open-ended fund can be worked out, it would provide references for fund managers and investors, and risk management of open-ended fund would have practical value.Therefore, the second purpose of this study is to measure the liquidity risk of Chinese open-end funds through the LVaR model that this paper constructs and to discuss the LVaR model’s applications in the management of liquidity risk. For example, make the optimal liquidation strategy of one stock or get the optimal underperform percentage when the fund is redeemed. After comparing the advantages and drawbacks of these three models’ construction methods and taking the special mechanism of open-ended fund’s liquidity risk and the order-driven trading mechanism of Chinese securities market into consideration, this paper chose the LVaR model based on the optimal trading strategy (OTS) to study the measurement and management of liquidity risk of Chinese open-ended funds. At present, most researches on LVaR model with OTS focused on the design of LVaR model’s building and the sensitivity analysis. However, there are very little studies about the quantitative research of the value of LVaR. Only a few scholars analyzed the portfolio’s LVaR by building a relatively simple model and assuming some data. These methods have many problems such as too many assumptions, lack of theoretical proof, poor accuracy of estimates, and so on. Therefore, this article attempts to relax some assumptions to construct an LVaR model, and then to analyze the measurement and management of liquidity risk of Chinese open-ended funds.Firstly, the domestic and international theories were introduced, including the LVaR model based on bid-ask spread, optimal trading strategy method and adjusting position’s holding period. Then, the LVaR model that this paper attempts to construct is described in the introduction and implementation of methods. This paper supposes that financial asset follows an arithmetic random walk and brings in the Market Impact model (MI) according to OTS, and assumes that price shock function is linear function and the bid-ask spread and impact coefficient is not constant but a random variable. As a result, implement cost for trading is also a random variable. Then according to mean-variance principle we construct the model, and the optimal liquidation strategy is worked out, so is LVaR which is modified by liquidity. Then we assume that open-end fund portfolio remains the same in holding period, and bonds and other assets are not affected by liquidity risk, and the top ten stocks held by open-end fund are its whole portfolio. And we can use the previous LVaR model to measure liquidity risk of open-ended fund. Then, we analyze the sensitivity of LVaR and the optimal liquidation strategy about some parameters. After that we do a comparative analysis of optimal liquidation strategy and the optimal underperform percentage when open-end fund are in the event of large-scale redemption. This provides an available plan of Operation For the open-end fund. It also provides a practical guide on liquidity risk management of open-ended fund, as well as a series of policy recommendations. Finally, we analyze the research conclusions and shortcomings of this paper.Through this research, we get the following conclusions:(1) Comparing with the value of traditional VaR and LVaR, traditional one is much smaller than LVaR modified by liquidity. This indicates that the liquidity risk can not be ignored by Chinese stock market and open-ended funds.(2) It is found that the LVaR of three open-ended funds is higher than that of SH Index, which indicates that the liquidity risk of open-ended fund is worse than that of SH Index. This proves that the open-ended fund’s liquidity risk comes from the contradiction between assets liquidity and profitability. It is inevitable to face the higher liquidity risk while adopting open-ended fund of active investment strategy to pursue profits. It also indicates that open-ended fund has liquidity risk and one should pay much attention to manage and control the liquidity risk of open-ended fund.(3)Through the sensitivity analysis we find that, with the increase of initial quantity of stock, LVaR has a nonlinear increasing while traditional VaR remains the same. When the initial quantity is low, LVaR approximates to VaR. Bid- ask spread has a positive relationship with LVaR, the bigger the bid- ask spread, the worse the asset’s liquidity, and the higher the liquidity risk of this asset, the higher the LVaR. With the increase of initial values of market impact coefficient and standard deviation, the LVaR of realizing specific amount stocks increases. As a result, effects of market impact have a positive relationship with LVaR.(4) Then after the sensitivity analysis of the related parameter of the optimal liquidation strategy, we find that the optimal liquidation strategy is mainly sensitive to the rate of stock return, stock volatility, bid-ask spread volatility, instantaneous impact coefficient and instantaneous impact coefficient volatility. However, it is not sensitive to bid-ask spread, permanent impact coefficient and permanent impact coefficient volatility.(5) When one open-ended fund faces huge redemption, the optimization model of execution strategy can be constructed according to LVaR model. The portfolio stocks which are reduced their proportion by this way is the best method. According to the execution strategy of the optimization model, the open-ended fund suffers the lowest liquidity risk. Other execution strategies (such as equal reduction, proportional reduction, etc.) are not optimal. On the contrary, they cause higher liquidity risk than the execution strategy of the optimization model.Overall, the innovation of this paper is focused on the followings:First, this paper supposes that the stock price volatility follows an arithmetic random walk, brings in the market influence mechanism, suppose the price shock function is linear function. Different from other references, the market impact coefficients are constant. This paper takes the market impact coefficients as random variables which are more suitable to reality. According to Markowitz’s optimal portfolio theory, we construct the LVaR model which is modified by liquidity.Second, based on the LVaR model, we do sensitivity analysis on LVaR and the optimal liquidation strategy about some parameters. It is practical and instructive to do sensitivity analysis. For the fund managers, it has vital instructive significance.Third, combined with Chinese open-ended funds, with application of OTS, the LVaR model does open-ended funds liquidity risk measurement, and compares and analyzes optimal realizing strategy and optimal liquidation percentage, providing a practical management method and the suggestion of strategy investment.Last, with the advantages of LVaR model in measuring open-ended fund liquidity risk and managing liquidity risk, the LVaR model is in accordance with the practical situation of Chinese open-ended funds, which will make the regulatory more reasonable and effective.After many improvements, there are still some deficiencies in this article that could be improved. The LVaR model this paper constructs can not dynamically reflect changes about market conditions. It assumes that once the trading strategies are determined, the trading strategies will not change no longer even if there were some other market events happened. If we reconsider the liquidation strategy of the remaining assets in the middle period, the transaction path and LVaR will change. The dynamic liquidation strategies have more practical significance, but the study will be more complicated. The latest foreign study about LVaR model brings the dynamic liquidation strategy. It’s better to reflect market conditions changes, and better for the open-end funds’ liquidity risk management. So considering the dynamic liquidation strategy is the future research direction of this article.