The world price of liquidity risk Lee, Kuan-Hui
Journal of financial economics,
2011, 2011-1-00, 20110101, Volume:
99, Issue:
1
Journal Article
Peer reviewed
This paper empirically tests the liquidity-adjusted capital asset pricing model of
Acharya and Pedersen (2005) on a global level. Consistent with the model, I find evidence that liquidity risks are ...priced independently of market risk in international financial markets. That is, a security’s required rate of return depends on the covariance of its own liquidity with aggregate local market liquidity, as well as the covariance of its own liquidity with local and global market returns. I also show that the US market is an important driving force of global liquidity risk. Furthermore, I find that the pricing of liquidity risk varies across countries according to geographic, economic, and political environments. The findings show that the systematic dimension of liquidity provides implications for international portfolio diversification.
We provide the first systematic study of liquidity in the foreign exchange market. We find significant variation in liquidity across exchange rates, substantial illiquidity costs, and strong ...commonality in liquidity across currencies and with equity and bond markets. Analyzing the impact of liquidity risk on carry trades, we show that funding (investment) currencies offer insurance against (exposure to) liquidity risk. A liquidity risk factor has a strong impact on carry trade returns from 2007 to 2009, suggesting that liquidity risk is priced. We present evidence that liquidity spirals may trigger these findings.
This paper evaluates hedge funds that grant favorable redemption terms to investors. Within this group of purportedly liquid funds, high net inflow funds subsequently outperform low net inflow funds ...by 4.79% per year after adjusting for risk. The return impact of fund flows is stronger when funds embrace liquidity risk, when market liquidity is low, and when funding liquidity, as measured by the Treasury-Eurodollar spread, aggregate hedge fund flows, and prime broker stock returns, is tight. In keeping with an agency explanation, funds with strong incentives to raise capital, low manager option deltas, and no manager capital co-invested are more likely to take on excessive liquidity risk. These results resonate with the theory of funding liquidity by
Brunnermeier and Pedersen (2009).
Liquidity dried up during the financial crisis of 2007–2009. Banks that relied more heavily on core deposit and equity capital financing, which are stable sources of financing, continued to lend ...relative to other banks. Banks that held more illiquid assets on their balance sheets, in contrast, increased asset liquidity and reduced lending. Off-balance sheet liquidity risk materialized on the balance sheet and constrained new credit origination as increased takedown demand displaced lending capacity. We conclude that efforts to manage the liquidity crisis by banks led to a decline in credit supply.
Banks can create liquidity for firms by pooling their idiosyncratic risks. As a result, bank lines of credit to firms with greater aggregate risk should be costlier and such firms opt for cash in ...spite of the incurred liquidity premium. We find empirical support for this novel theoretical insight. Firms with higher beta have a higher ratio of cash to credit lines and face greater costs on their lines. In times of heightened aggregate volatility, banks exposed to undrawn credit lines become riskier; bank credit lines feature fewer initiations, higher spreads, and shorter maturity; and, firms' cash reserves rise.
We examine the dynamics and the drivers of market liquidity during the financial crisis, using a unique volume-weighted spread measure. According to the literature we find that market liquidity is ...impaired when stock markets decline, implying a positive relation between market and liquidity risk. Moreover, this relationship is the stronger the deeper one digs into the order book. Even more interestingly, this paper sheds further light on so far puzzling features of market liquidity: liquidity commonality and flight-to-quality. We show that liquidity commonality varies over time, increases during market downturns, peaks at major crisis events and becomes weaker the deeper we look into the limit order book. Consistent with recent theoretical models that argue for a spiral effect between the financial sector’s funding liquidity and an asset’s market liquidity, we find that funding liquidity tightness induces an increase in liquidity commonality which then leads to market-wide liquidity dry-ups. Therefore our findings corroborate the view that market liquidity can be a driving force for financial contagion. Finally, we show that there is a positive relationship between credit risk and liquidity risk, i.e., there is a spread between liquidity costs of high and low credit quality stocks, and that in times of increased market uncertainty the impact of credit risk on liquidity risk intensifies. This corroborates the existence of a flight-to-quality or flight-to-liquidity phenomenon also on the stock markets.
Value and Momentum Everywhere ASNESS, CLIFFORD S.; MOSKOWITZ, TOBIAS J.; PEDERSEN, LASSE HEJE
The Journal of finance (New York),
June 2013, Volume:
68, Issue:
3
Journal Article
Peer reviewed
Open access
We find consistent value and momentum return premia across eight diverse markets and asset classes, and a strong common factor structure among their returns. Value and momentum returns correlate more ...strongly across asset classes than passive exposures to the asset classes, but value and momentum are negatively correlated with each other, both within and across asset classes. Our results indicate the presence of common global risks that we characterize with a three-factor model. Global funding liquidity risk is a partial source of these patterns, which are identifiable only when examining value and momentum jointly across markets. Our findings present a challenge to existing behavioral, institutional, and rational asset pricing theories that largely focus on U.S. equities.
We examine the dynamics and the drivers of market liquidity during the financial crisis, using a unique volume-weighted spread measure. According to the literature we find that market liquidity is ...impaired when stock markets decline, implying a positive relation between market and liquidity risk. Moreover, this relationship is the stronger the deeper one digs into the order book. Even more interestingly, this paper sheds further light on so far puzzling features of market liquidity: liquidity commonality and flight-to-quality. We show that liquidity commonality varies over time, increases during market downturns, peaks at major crisis events and becomes weaker the deeper we look into the limit order book. Consistent with recent theoretical models that argue for a spiral effect between the financial sector’s funding liquidity and an asset’s market liquidity, we find that funding liquidity tightness induces an increase in liquidity commonality which then leads to market-wide liquidity dry-ups. Therefore our findings corroborate the view that market liquidity can be a driving force for financial contagion. Finally, we show that there is a positive relationship between credit risk and liquidity risk, i.e., there is a spread between liquidity costs of high and low credit quality stocks, and that in times of increased market uncertainty the impact of credit risk on liquidity risk intensifies. This corroborates the existence of a flight-to-quality or flight-to-liquidity phenomenon also on the stock markets.
Hedge Fund Contagion and Liquidity Shocks BOYSON, NICOLE M.; STAHEL, CHRISTOF W.; STULZ, RENÉ M.
The Journal of finance (New York),
October 2010, Volume:
65, Issue:
5
Journal Article
Peer reviewed
Defining contagion as correlation over and above that expected from economic fundamentals, we find strong evidence of worst return contagion across hedge fund styles for 1990 to 2008. Large adverse ...shocks to asset and hedge fund liquidity strongly increase the probability of contagion. Specifically, large adverse shocks to credit spreads, the TED spread, prime broker and bank stock prices, stock market liquidity, and hedge fund flows are associated with a significant increase in the probability of hedge fund contagion. While shocks to liquidity are important determinants of performance, these shocks are not captured by commonly used models of hedge fund returns.