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Copyright, Yogesh Malhotra, PhD, 2012 www.yogeshmalhotra.com Framework of Liquidity Risk Assessment for JP Morgan Private Bank $500B Fund of Funds Multi-Asset Portfolio Construction & Optimization Liquidity Risk / Cost Illiquidity Cost Liquidity Premium RISK RETURN Liquidity Score Liquidity Index LIQUIDITY Quantitative MODEL Qualitative - Stress Testing Stochastic Deterministic - Scenarios Minimize Model Risk Portfolio Measures at Portfolio Level Correlations Across Vehicles and Asset Classes Correlations Across Vehicles and Asset Classes Aggregates Assets Measures for Various Asset Classes Capture Diversity of Risk Assets Preserve Core Parameters for Aggregates f (size, complex, convertible) Sharpe Ratio Liquidity Risk Liquidity Insurance Funding Liquidity Risk Idiosyncratic Risk (Endogenous) Market Risk (Exogenous) Time Horizon Maturity Duration Convexity Volatility Autocorrelations Returns Stress Tests Price Discovery "Market risk can hurt you, but liquidity risk can kill you." With market risk and credit risk, you could lose a fortune. With liquidity risk, you could lose the bank!

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Copyright, Yogesh Malhotra, PhD, 2012 www.yogeshmalhotra.com Current State of Liquidity Research Regulators Academics Practitioners Liquidity and Solvency Systemic Risk of Failure Two Minimum Standards (Funding Liquidity Buffers) Liquidity Coverage Ratio, 30 - High Quality Liquid Assets Net Stable Funding Ratio - Minimum Stable Funding Measure, Monitor, Manage Currencies | Stress Testing Forward Liquidity Exposure Counter-Balancing Capacity - Liquidity Buffer (Fiedler) - BSL = CBC - FLE - Transfer Pricing of Liquidity Liquification Algorithm/Score - Term Structure, Repo, FAI Interest Rate Risk Gaps & Liquidity Risk Gaps (Matz) LG: A&L |CF (Time) RG: A&L |Re-Price (Time) "Liquidity is a great metaphor, but we still don't have an unambiguous definition of it." LVaR = position ($) * [-drift (%) + volatility *deviate + LC]; 0.5*spread " No single measure captures the various aspects of liquidity in financial markets."

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Copyright, Yogesh Malhotra, PhD, 2012 www.yogeshmalhotra.com Current State of Liquidity Risk Measures Assets: Specific Assets: General Coherent Measures Popular Liquidity Models (Price, Quantity, Time) Bid-Ask Spread Exogenous Position Size Endogenous Resiliency (Rare) Trading Volume (Flawed) - Flash Crash Aggregates of Multiple Basic Liquidity Measures Long-Short Index Measure Chacko, Das, Fan (2012) Long the ETFs Short components of ETFs Liquidity as Shadow Asset: Kinlaw et al. (2012) - Identify optimal weights by maximizing expected utility - Substitute illiquid asset for liquid equity - Solve for illiquid asset return based on σ and ρ - Estimate AR(1) Model using least squares - De-smooth the time series Liquidity as Real Option: Ang & Bollen (2008) Investors decision to withdraw capital: real option Lockups & Notice periods: exercise restrictions: reduction in the value of liquidity option. Bangia et al. (2001)Berkowitz (2000) Giot & Gramming (2005)Stange and Kaserer (2008) Tightness, Depth, Resilience (Kyle, 1985) Aggregates of Multiple Basic Liquidity Measures Bid Ask, Volume, Turnover, Loeb Price Impact (Lo 2010) (Amount of Trading, Cost) Serial Correlation as proxy. Liquidity Adjusted CAPM (Acharya & Pedersen, 2005 JFE) Risky and has Commonality Constant Trading Frictions Volume Weighted Spreads 1. Bid Ask Spread, 2.Transactions (Volume), 3.Volume Weighted Spreads Comparing individual assets liquidities is problematic because one asset could be more liquid along one dimension of transaction costs while the other is more liquid in a different dimension. "No bank can ever afford to hold enough liquidity during normal times to be able to survive a severe or prolonged funding disruption." Basel Committee Jarrow & Protter (2005)

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Copyright, Yogesh Malhotra, PhD, 2012 www.yogeshmalhotra.com Autocorrelation Measure of Relative Liquidity & Setup for a Wall Street Asset Management Firm Assets: Specific Assets: General Portfolio Scale for Relative Liquidity How fast price (t) decays - Faster decay, more liquid How long stale price (t) lasts - More it affects, less liquid - Longer it lasts, less liquid Y Proxy for Liquidity Risk Plot serial correlations Use Model to find Decay Measure Decay Factor "Liquidity risk today is where credit risk was 10 years ago." " In times of financial crisis, asset prices in some markets may reflect the amount of liquidity available in the market rather than the future earning power of the asset."

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Copyright, Yogesh Malhotra, PhD, 2012 www.yogeshmalhotra.com Alternative Investments Liquidity Fund of Funds Post-2008 Trends Requiring Research Advances for Wall Street Firm Multi-Asset Portfolio of 16 Asset Classes New Global Risk Indicators Credit spreads Bid-Ask Spreads Trade Volumes Correlation Matrices Forward Duration Curves Positions Outstanding New Macro Risk Indicators Systemic vs. Specific Risk Tradition VIX as Indicator Breakdown of VIX, Volatility Non-Normal Returns Chaotic Returns No Risk-Free Rates Inflation Expectations Future Volatility Concerns Future Credit Concerns Sovereign Default "I'd just caution you that models are backward-looking. The future isnt the past." " People have known since Mandelbrot in 1963 that returns are not normally distributed."

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Copyright, Yogesh Malhotra, PhD, 2012 www.yogeshmalhotra.com Framework of Liquidity Assessment for Wall Street Asset Management Firms Multi-Asset Portfolio Construction & Optimization Liquidity [Risk] Measures: Asset Classes, Aggregates, Portfolio Framework 16-Asset Class Portfolio Liquidity Assessment Defined Asset Classes & Aggregates (Vehicles) Endogenous Liquidity: Time / Maturity / Duration, Volatility / Autocorrelations, Returns / Stress Tests: Price Discovery 16-Asset Class Portfolio Optimization: Sharpe / Liquidity Risk / Liquidity Insurance Funding Liquidity Risk, Asset Liquidity Risk Idiosyncratic (Endogenous), Market (Exogenous) Models: Quantitative + Qualitative, Stochastic + Deterministic Stress Testing Scenarios Minimize Model Risk Assets Modeled: Hedge Funds (HF), Alternative Investments, Equities, Commodities, Fixed Income, Bonds, Currencies " Normality has been an accepted wisdom in economics and finance for a century or more. Yet in real-world systems, nothing could be less normal than normality. Tails should not be unexpected, for they are the rule. "

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Copyright, Yogesh Malhotra, PhD, 2012 www.yogeshmalhotra.com Portfolio Construction Framework: An Overview "It is truly an art to build a long-term robust quantitative model that will perform well out-of-sample and through several different types of market environments.

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Copyright, Yogesh Malhotra, PhD, 2012 www.yogeshmalhotra.com Implementation Model VALIDATE SIMULATE MODELS / MEASURES Market Data Data Feeds Other Updates REPLICATE PARAMETERS STRESS TESTS SHOCKS "I think you should be ambitious about your models, and push them as far as you can, but you need to be aware they will fail - and under what circumstances.

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