In terms of LVaR, how is it calculated?

The calculation of Liquidity Value at Risk (LVaR) takes into account the traditional Value at Risk (VaR), which estimates potential losses in the value of an asset or portfolio over a set time frame under normal market conditions. However, LVaR introduces an additional adjustment for liquidity risk, which is reflected in the bid-ask spread.

The rationale behind the correct formulation is that it recognizes that the bid-ask spread represents a cost that can affect the realization of asset sales during a downturn or in times of distress. By multiplying the stock holding by the bid-ask spread and dividing by 2, the equation captures the average implied cost of executing trades in the market due to liquidity constraints. This adjustment effectively reflects a more realistic scenario of the potential losses that could be faced by an investor needing to liquidate positions quickly in a liquidity-challenged environment.

Thus, by adding this liquidity adjustment to VaR, the LVaR provides a more comprehensive risk measure that encompasses not only market risk but also the risk associated with the inability to quickly buy or sell assets without incurring significant costs. This makes LVaR a critical tool for risk managers looking to mitigate potential impacts on portfolios during periods of market stress.