How do you benchmark and compare your market risk and liquidity risk adjustments with peers and competitors? (2024)

Benchmarking and comparing your market risk and liquidity risk adjustments with peers and competitors can help you to assess your relative performance, identify areas of improvement, and communicate your value proposition to investors, lenders, and other stakeholders. By using consistent and transparent methods and data sources, you can also enhance your credibility and avoid potential disputes or challenges.

One of the most common ways to measure market risk is to use the Value at Risk (VaR) method, which estimates the maximum potential loss of a portfolio or an asset over a given time horizon and confidence level, based on historical or simulated data. For example, a 10-day 95% VaR of $1 million means that there is a 5% chance that the portfolio or asset will lose more than $1 million in 10 days. You can compare your VaR with your peers and competitors by using the same time horizon, confidence level, and data source, and by adjusting for any differences in portfolio size, composition, or risk profile.

One of the most common ways to measure liquidity risk is to use the bid-ask spread, which is the difference between the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept for an asset. The bid-ask spread reflects the cost of trading and the availability of buyers and sellers in the market. A higher bid-ask spread indicates a lower liquidity and a higher liquidity risk. You can compare your bid-ask spread with your peers and competitors by using the same asset class, market segment, and time period, and by adjusting for any differences in asset quality, maturity, or volatility.

To adjust for market risk, you need to estimate the required return or discount rate for your portfolio or asset, based on the risk-free rate and the market risk premium. The risk-free rate is the return on a hypothetical investment with no risk, such as a government bond. The market risk premium is the excess return that investors demand for investing in a risky asset, such as a stock or a corporate bond. You can use the Capital Asset Pricing Model (CAPM) or other models to estimate the market risk premium, based on the beta or the sensitivity of your portfolio or asset to the market movements. You can compare your required return or discount rate with your peers and competitors by using the same risk-free rate, market risk premium, and beta, and by adjusting for any differences in leverage, growth, or cash flow.

To adjust for liquidity risk, you need to estimate the liquidity premium or discount for your portfolio or asset, based on the bid-ask spread and the expected holding period. The liquidity premium or discount is the additional return or reduction in value that investors demand or accept for investing in a less liquid asset, such as a private equity or a real estate. You can use the Liquidity Adjusted CAPM (LCAPM) or other models to estimate the liquidity premium or discount, based on the bid-ask spread, the expected holding period, and the beta of your portfolio or asset. You can compare your liquidity premium or discount with your peers and competitors by using the same bid-ask spread, expected holding period, and beta, and by adjusting for any differences in asset quality, maturity, or volatility.

In order to benchmark and compare your market risk and liquidity risk adjustments with peers and competitors, reliable and relevant tools and data sources should be used. These include financial databases such as Bloomberg, Thomson Reuters, or Capital IQ which provide market data, financial statements, and analyst reports for various asset classes and sectors. Additionally, risk management software like RiskMetrics, Value at Risk, or Monte Carlo Simulation can be used to calculate VaR, simulate scenarios, and perform sensitivity analysis for your portfolio or asset. Valuation software such as Excel, DCF, or Multiples enable you to estimate the required return, discount rate, liquidity premium, or discount for your portfolio or asset based on different models and assumptions. Lastly, benchmarking reports such as Industry Surveys, Peer Group Analysis, or Comparative Valuation provide useful insights into the market risk and liquidity risk adjustments of your peers and competitors as well as their performance, valuation, and outlook.

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