Financial turbulence is a phenomenon usually occurs in anti-persistent markets. In contrast, financial crises tend to occur in persistent markets. A relationship can be established between these two extreme long memory phenomena and the older financial concept of (il-)liquidity. The measurement of the degree of market persistence and the measurement of the degree of market liquidity are related. To accomplish the scientific research objectives of measurement, analysis and simulation of different degrees of financial liquidity in the financial markets, this paper proposes to reformulate and reinterpret the classical laws of fluid mechanics into financial cash flow mechanics. The end results of these reformulations and reinterpretations are useful, and often already familiar, quantifiable financial quantities, which will assist in the measurement, analysis, and proper characterization of modern dynamic financial markets in ways that classical comparative static financial-economic analyses simply do not allow. The motivation for this study is directly derived from the currently increased turmoil in the globally linked financial markets, caused by the valuation adjustments emerging from the sharply adjusting residential housing markets, which are transmitted with increased speed via the swap markets, in particular the Credit Default Swap (CDS) markets.

In the past decade, the accurate measurement of financial illiquidity risk has dramatically gained in importance, almost geometrically in the past few years. This is obvious when we look at the early example of the taxpayer-financed bail out of the Russian-default-traumatized Long Term Capital Management (LTCM) hedge fund in 1998 and compare that with the recent March 2008 example of the Federal Reserve—JP Morgan engineered electroshock of an already flat-lined mortgage portfolios-processing, Bear Sterns, or the more diversified Lehman Brothers. The LTCM debacle was considered an isolated incident. But recent history shows that it was just a predecessor of the current series of collapses of major financial houses. Therefore, this study first looks at LTCM in detail. It applied a trading strategy known as ‘convergence arbitrage’, which is based on the idea that when two securities have the same theoretical price, because they have the same return-risk profile, their market prices should eventually be the same. But this convergence strategy ignores the observation that financial risk is a time-dependent or long memory phenomenon and not a time-independent or no memory phenomenon to which the usual central limit theory based on i.i.d. assumptions applies. Indeed, in the summer of 1998, LTCM made a huge loss of $4 bn. This was triggered off when Russia suddenly and unexpectedly defaulted on its debt, which caused a flight to quality in the German bond market.

LTCM itself did not have a large exposure to Russian debt, but it tended to be long illiquid German (off-the-run) bonds and the short corresponding liquid German (on-the-run) bonds. The spreads between the prices of the illiquid bonds and the corresponding liquid bonds widened sharply and immediately after the Russian default and it suddenly imposed absolute illiquidity of the Russian debt. Credit default spreads also increased and LTCM was highly leveraged, with a debt/equity ratio of close to 300, so that the loss of profits on its spread hedges immediately translated into a very rapid vanishing of its market valued equity and threatened bankruptcy. When it was unable to make its projected ‘risk-free’ arbitrage profits, it experienced huge losses and there were margin calls on its positions which it was unable to meet.

LTCM’s position was made more difficult by the fact that over a period of three years many other hedge funds had also learned this game of “gigantically vacuuming pennies all over the world” and implemented similar convergence arbitrage strategies.2 When LTCM tried to liquidate part of its portfolio to meet its margin calls, by selling its illiquid off-the-run bonds and by buying its liquid on-the-run bonds, other hedge funds faced with similar problems did similar trades at the same time. Consequently, the price of the on-the-run bonds rose sharply relative to the price of the off-the-run bonds. This caused the illiquidity spreads to widen even further and to reinforce the original flight to quality. Thus, the illiquidity problem was exacerbated and not alleviated by the crowding effect. This was a clear example of a long-term illiquidity risk dependence accumulation that was not foreseen by the time-independence assumptions of geometric Brownian motion arbitrage models used by LTCM’s managers and partners, which assumes perfectly competitive, generally liquid markets.

Financial Cash Flow, Term Structure Dynamics, Turbulent Global Markets, Financial illiquidity risk, Long Term Capital Management, LTCM, Credit Default Swap, CDS, Reinterpretations, Kinetic viscosity, Arbitrage strategies, Liquid markets.