Recherche en Finance: Integrating liquidity risk in portfolio choice

As the recent crisis unfolded, liquidity risk became a major topic. Actually, liquidity is generally an issue during stress situations. Decision variables that were independent, or supposed to be independent, suddenly become highly correlated. This phenomenon is known as the “phase locking effect”. The notion stems from biology and was originally documented in biological systems where the automatic synchronization of the flickering of Southeast Asian fireflies was described. Recent research has suggested that the “phase-locking behaviour” can be modelled with a dummy variable added to factor models such as APT or CAPM. The dummy is supposed to catch return variations due to systemic shocks. The systemic shock dummy can then be used to distinguish between unconditional and conditional correlations, where the latter denote the correlations during stress situations. Those conditional correlations should actually be used to implement stress tests. Incidentally, note that even though unconditional correlations can be more or less zero, the conditional correlation can be quite close to unity.

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