The Consequences of Basel III Requirements for Liquidity Horizon and It's Implication on Optimal Trading Strategy

In this work we introduce a formula-based approach to calculate optimal liquidity horizons (LH) for the purpose of scaling the base expected shortfall (ES) as required under current market risk capital requirements from Basel Committee. We used “half-life” formula from Almgren and Chriss (2000) to compute the optimal LH and constructed an optimal expected shortfall (OES) measure, which allows for more precise ES estimation by scaling the ES of an individual security level rather than an aggregated group of risk factors as outlined in Basel (2019). We compared the efficiency of OES to the current regulatory expected shortfall (RES) on SP500 and DJIA indices returns data using regression-based ES backtesting from Bayer, S., & Dimitriadis, T. (2018), and found that the OES measure is unbiased, whereas the RES consistently overestimates the true values of ES.