Malz explains that marking to model can underestimate liquidity risk. From his example, I don't see it. I can see us underestimating market risk because we are using an incorrect price.
Why does a divergence between the market and model prices cause liquidity risk ?
Another example is convertible bond trading. Convertible bonds can be mapped to a set of risk factors including implied volatilities, interest rates, and credit spreads. Such mappings are based on the theoretical price of a convertible bond, which is arrived at using its replicating portfolio. However, theoretical and market prices of converts can diverge dramatically. These divergences are liquidity risk events that are hard to capture with market data, so VaR based on the replicating portfolio alone can drastically understate risk. Stress testing can mitigate the problem.