Lot of focus has been shifted on liquidity risk management. Basel committee also planning to recommended that holding period of VaR calculation should be based on asset classes and time required to unwind the positions. It is understood that liquidity affects risk management because if markets are not liquid than it will take more time to unwind the positions. Interestingly risk management also affects the liquidity. Tighter risk management reduces liquidity, which in turn leads to tighter risk management, etc. This can help explain sudden drops in liquidity and, since liquidity is priced, in prices in connection with increased volatility or decreased risk-bearing capacity. This paper provides a model of the interaction between risk-management practices and market liquidity.
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