Lost in Contagion? Building a Liquidation Index from Covariance Dynamics

We present a tractable framework which links realized covariances to liquidation flows and asset liquidities via a feeback loop. We show the identifiability of model parameters which enables to build a dynamic indicator for fund liquidations. At every date t, this indicator that we call the liquidation index captures the magnitude of fire sales during a given period [t −tau, t] by taking into account the movements of prices, covariances and liquidities over that period. We explore the properties of this indicator and show its stability and robustness. We study the liquidation index empirically on the US, French and Brazilian stock markets and show that spikes of the liquidation index indeed correspond to periods of fire sales. This makes the liquidation index useful in a perspective of (systemic) risk management as it enables to detect the beginning and the end of a liquidation period as well as capture the magnitude of such liquidations. We also compare this indicator to other benchmark indicators and show that it is a better measure for fire sales