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Liquidity: Empirical Perspectives

Paper Session

Saturday, Jan. 6, 2018 10:15 AM - 12:15 PM

Loews Philadelphia, Commonwealth Hall B
Hosted By: American Finance Association
  • Chair: Nicolae Gârleanu, University of California-Berkeley

Asset Mispricing

Kurt Lewis
,
Federal Reserve Board
Francis Longstaff
,
University of California-Los Angeles
Lubomir Petrasek
,
Federal Reserve Board

Abstract

We use a unique dataset of corporate bonds guaranteed by the full faith and credit of the U.S. to test a number of recent theories about why asset prices may diverge from fundamental values. These models emphasize the role of funding liquidity, slow-moving capital, the leverage of financial intermediaries, and other frictions in allowing mispricing to occur. Consistent with theory, we find there are strong patterns of commonality in mispricing and that changes in dealer haircuts and funding costs are significant drivers of mispricing. Furthermore, mispricing can trigger short-term margin and funding-cost spirals. Using detailed bond and dealer-level data, we find that most of the cross-sectional variation in mispricing is explained by differences in dealer funding costs, inventory positions, and trading liquidity measures. These results provide strong empirical support for a number of current theoretical models.

Funding Liquidity Risk and the Cross-section of MBS Returns

Yuriy Kitsul
,
Federal Reserve Board
Marcelo Ochoa
,
Federal Reserve Board

Abstract

This paper shows that funding liquidity risk is priced in the cross-section of excess
returns on agency mortgage-backed securities (MBS). We derive a measure of funding
liquidity risk from dollar-roll implied financing rates (IFRs), which reflect security-level
costs of financing MBS positions. We show that factors representing higher net MBS
supply are associated with higher funding costs. We also find that funding liquidity
risk is compensated in the cross-section of expected returns—securities that are better
hedges against market-wide funding liquidity shocks on average deliver lower excess
returns—and that this premium is separate from compensation for prepayment risk.

Funding Liquidity Shocks in a Quasi-Experiment: Evidence from the CDS Big Bang

Xinjie Wang
,
Southern University of Science and Technology
Yangru Wu
,
Rutgers University
Hongjun Yan
,
DePaul University
Zhaodong (Ken) Zhong
,
Rutgers University

Abstract

A major regulatory event in April 2009, the so-called “CDS Big Bang,” induces upfront fees for trading CDSs. This funding shock, combined with several other shocks that took place soon afterwards (the CDS Small Bang, central clearing, and Deutsche Bank’s exit from the CDS market) offers a rich setup to not only quantify the negative market liquidity effect from funding shocks, but also examine the economic mechanism behind this effect. This funding shock also increases the absolute value of the CDS-bond basis, and the effect is stronger if arbitrageurs are the payers, rather than the receivers, of the upfront fees.

Dimensional Analysis, Leverage Neutrality, and Market Microstructure Invariance

Albert S. Kyle
,
University of Maryland
Anna Obizhaeva
,
New Economic School

Abstract

This paper combines dimensional analysis, leverage neutrality, and a principle of market microstructure invariance to derive scaling laws expressing transaction costs functions, bid-ask spreads, bet sizes, number of bets, and other financial variables in terms of dollar trading volume and volatility. The scaling laws are illustrated using data on bid-ask spreads and number of trades for Russian and U.S. stocks. These scaling laws provide practical metrics for risk managers and traders; scientific benchmarks for evaluating controversial issues related to high frequency trading, market crashes, and liquidity measurement; and guidelines for designing policies in the aftermath of financial crisis.
Discussant(s)
Robin Greenwood
,
Harvard Business School
Adi Sunderam
,
Harvard University
David Lando
,
Copenhagen Business School
Dmitry Livdan
,
University of California-Berkeley
JEL Classifications
  • G1 - General Financial Markets