Market liquidity and funding liquidity

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Market liquidity and funding liquidity

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Market liquidity and funding liquidity

Markus K. Brunnermeier¹, Lasse Heje Pedersen²•Institutions (2)

Princeton University¹, New York University²

01 Feb 2007-Research Papers in Economics (Financial Markets Group)-

TL;DR: In this article, the authors provide a model that links an asset's market liquidity and traders' funding liquidity, i.e., the ease with which they can obtain funding, to explain the empirically documented features that market liquidity can suddenly dry up, has commonality across securities, is related to volatility, is subject to flight to quality, and comoves with the market.

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Abstract: We provide a model that links an asset's market liquidity - i.e., the ease with which it is traded - and traders' funding liquidity - i.e., the ease with which they can obtain funding. Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and the margins they are charged, depend on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to “flight to quality¶, and (v) comoves with the market, and it provides new testable predictions. Keywords: Liquidity Risk Management, Liquidity, Liquidation, Systemic Risk, Leverage, Margins, Haircuts, Value-at-Risk, Counterparty Credit Risk

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Journal Article•DOI•

Deciphering the Liquidity and Credit Crunch 2007-08

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Markus K. Brunnermeier¹•Institutions (1)

Princeton University¹

17 Dec 2008-Social Science Research Network

TL;DR: The authors summarizes and explains the main events of the liquidity and credit crunch in 2007-08, starting with the trends leading up to the crisis and explaining how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.

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Abstract: This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.

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3,033 citations

Cites background from "Market liquidity and funding liquid..."

...Source: Brunnermeier and Pedersen (2009)....
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...Brunnermeier and Pedersen (2009) show that a vicious cycle emerges, where higher margins and haircuts force de-leveraging and more sales, which increase margins further and force more sales, leading to the possibility of multiple equilibria....
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...It is useful to divide the concept of liquidity into two categories: funding liquidity and market liquidity (Brunnermeier and Pedersen, 2009)....
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...positions at fire-sale prices. ( Brunnermeier and Pedersen, 2005 )....
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...5 First, unexpected price shocks may be a harbinger of higher future volatility (Brunnermeier and Pedersen, 2009)....
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Journal Article•DOI•

Liquidity and Leverage

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Tobias Adrian¹, Hyun Song Shin²•Institutions (2)

International Monetary Fund¹, Bank for International Settlements²

01 Jan 2009-Social Science Research Network

TL;DR: In a financial system in which balance sheets are continuously marked to market, asset price changes appear immediately as changes in net worth, eliciting responses from financial intermediaries who adjust the size of their balance sheets as mentioned in this paper.

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Abstract: In a financial system in which balance sheets are continuously marked to market, asset price changes appear immediately as changes in net worth, eliciting responses from financial intermediaries who adjust the size of their balance sheets. We document evidence that marked-to-market leverage is strongly procyclical. Such behavior has aggregate consequences. Changes in dealer repos—the primary margin of adjustment for the aggregate balance sheets of intermediaries—forecast changes in financial market risk as measured by the innovations in the Chicago Board Options Exchange Volatility Index (VIX). Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries.

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1,950 citations

Book Chapter•DOI•

Financial Intermediation and Credit Policy in Business Cycle Analysis

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Mark Gertler¹, Nobuhiro Kiyotaki¹•Institutions (1)

Princeton University¹

01 Jan 2010-Handbook of Monetary Economics

TL;DR: The authors developed a canonical framework to think about credit market frictions and aggregate economic activity in the context of the current crisis, and used the framework to address two issues in particular: first, how disruptions in financial intermediation can induce a crisis that affects real activity; and second, how various credit market interventions by the central bank and the Treasury of the type we have seen recently, might work to mitigate the crisis.

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Abstract: We develop a canonical framework to think about credit market frictions and aggregate economic activity in the context of the current crisis. We use the framework to address two issues in particular: first, how disruptions in financial intermediation can induce a crisis that affects real activity; and second, how various credit market interventions by the central bank and the Treasury of the type we have seen recently, might work to mitigate the crisis. We make use of earlier literature to develop our framework and characterize how very recent literature is incorporating insights from the crisis.

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1,900 citations

Cites background from "Market liquidity and funding liquid..."

...3 Let ht be the Lagrangian multiplier for the incentive constraint (11) faced by bank of type h and t P...
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Journal Article•DOI•

Presidential Address: Discount Rates

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John H. Cochrane

01 Aug 2011-Journal of Finance

TL;DR: Discount-rate variation is the central organizing question of current asset-pricing research as discussed by the authors, and a survey of discount-rate theories and applications can be found in the survey.

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Abstract: Discount-rate variation is the central organizing question of current asset-pricing research. I survey facts, theories, and applications. Previously, we thought returns were unpredictable, with variation in price-dividend ratios due to variation in expected cashflows. Now it seems all price-dividend variation corresponds to discount-rate variation. We also thought that the cross-section of expected returns came from the CAPM. Now we have a zoo of new factors. I categorize discount-rate theories based on central ingredients and data sources. Incorporating discount-rate variation affects finance applications, including portfolio theory, accounting, cost of capital, capital structure, compensation, and macroeconomics.

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1,624 citations

Cites background from "Market liquidity and funding liquid..."

...41 Brunnermeier (2009) and Brunnermeier and Pedersen (2009), for example....
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Journal Article•DOI•

Betting Against Beta

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Andrea Frazzini, Lasse Heje Pedersen

09 Oct 2011-Social Science Research Network

TL;DR: This paper presented a model with leverage and margin constraints that vary across investors and time, and found evidence consistent with each of the model's five central predictions: constrained investors bid up high-beta assets, high beta is associated with low alpha, as they find empirically for U.S. equities, 20 international equity markets, Treasury bonds, corporate bonds, and futures.

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Abstract: We present a model with leverage and margin constraints that vary across investors and time. We find evidence consistent with each of the model’s five central predictions: (1) Since constrained investors bid up high-beta assets, high beta is associated with low alpha, as we find empirically for U.S. equities, 20 international equity markets, Treasury bonds, corporate bonds, and futures; (2) A betting-against-beta (BAB) factor, which is long leveraged low beta assets and short high-beta assets, produces significant positive risk-adjusted returns; (3) When funding constraints tighten, the return of the BAB factor is low; (4) Increased funding liquidity risk compresses betas toward one; (5) More constrained investors hold riskier assets.

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1,431 citations

Cites background from "Market liquidity and funding liquid..."

...Furthermore, funding liquidity risk is linked to market liquidity risk (Gromb and Vayanos, 2002; Brunnermeier and Pedersen, 2009), which also affects required returns (Acharya and Pedersen, 2005)....
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References

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Posted Content•DOI•

Credit Rationing in Markets with Imperfect Information.

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Joseph E. Stiglitz, Andrew Weiss

01 Jan 1981-The American Economic Review

TL;DR: In this paper, a model is developed to provide the first theoretical justification for true credit rationing in a loan market, where the amount of the loan and amount of collateral demanded affect the behavior and distribution of borrowers, and interest rates serve as screening devices for evaluating risk.

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Abstract: According to basic economics, if demand exceeds supply, prices will rise, thus decreasing demand or increasing supply until demand and supply are in equilibrium; thus if prices do their job, rationing will not exist. However, credit rationing does exist. This paper demonstrates that even in equilibrium, credit rationing will exist in a loan market. Credit rationing is defined as occurring either (a) among loan applicants who appear identical, and some do and do not receive loans, even though the rejected applicants would pay higher interest rates; or (b) there are groups who, with a given credit supply, cannot obtain loans at any rate, even though with larger credit supply they would. A model is developed to provide the first theoretical justification for true credit rationing. The amount of the loan and the amount of collateral demanded affect the behavior and distribution of borrowers. Consequently, faced with increased credit demand, it may not be profitable to raise interest rates or collateral; instead banks deny loans to borrowers who are observationally indistinguishable from those receiving loans. It is not argued that credit rationing always occurs, but that it occurs under plausible assumptions about lender and borrower behavior. In the model, interest rates serve as screening devices for evaluating risk. Interest rates change the behavior (serve as incentive mechanism) for the borrower, increasing the relative attractiveness of riskier projects; banks ration credit, rather than increase rates when there is excess demand. Banks are shown not to increase collateral as a means of allocating credit; although collateral may have incentivizing effects, it may have adverse selection effects. Equity, nonlinear payment schedules, and contingency contracts may be introduced and yet there still may be rationing. The law of supply and demand is thus a result generated by specific assumptions and is model specific; credit rationing does exist. (TNM)

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13,126 citations

"Market liquidity and funding liquid..." refers background in this paper

...…private information (Kyle (1985) and Glosten and Milgrom (1985)), inventory risk of market makers (e.g. Stoll (1978), Ho and Stoll (1981,1983) Ho and Stoll (1981) and Grossman and Miller (1988)), search frictions (Duffie, Gârleanu, and Pedersen (2003, 2003a)), or predatory trading…...
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...…order processing costs, private information (Kyle (1985) and Glosten and Milgrom (1985)), inventory risk of market makers (e.g. Stoll (1978), Ho and Stoll (1981,1983) Ho and Stoll (1981) and Grossman and Miller (1988)), search frictions (Duffie, Gârleanu, and Pedersen (2003, 2003a)), or…...
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Journal Article•DOI•

Continuous Auctions and Insider Trading

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Albert S. Kyle

01 Nov 1985-Econometrica

9,341 citations

"Market liquidity and funding liquid..." refers background in this paper

...A bank’s capital W consists of equity capital plus its long-term borrowings (including credit lines secured from individual or syndicates of commercial banks), reduced by assets that cannot be readily employed (e.g. goodwill, intangible assets, property, equipment, and capital needed for daily…...
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...…a security can be costly to trade — that is, has less than perfect market liquidity — because of exogenous order processing costs, private information (Kyle (1985) and Glosten and Milgrom (1985)), inventory risk of market makers (e.g. Stoll (1978), Ho and Stoll (1981,1983) Ho and Stoll (1981) and…...
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Journal Article•DOI•

Bank Runs, Deposit Insurance, and Liquidity

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Douglas W. Diamond, Philip H. Dybvig

01 Jun 1983-Journal of Political Economy

TL;DR: The authors showed that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits, and showed that there are circumstances when government provision of deposit insurance can produce superior contracts.

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Abstract: This paper shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Investors face privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple equilibria, one of which is a bank run. Bank runs in the model cause real economic damage, rather than simply reflecting other problems. Contracts which can prevent runs are studied, and the analysis shows that there are circumstances when government provision of deposit insurance can produce superior contracts.

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9,099 citations

"Market liquidity and funding liquid..." refers background or result in this paper

...Most of the banking literature follows Diamond and Dybvig (1983) in assuming an exogenous liquidation technology — that is, market liquidity is not endogenized....
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...However, as Bryant (1980) and Diamond and Dybvig (1983) show, banks are subject to bank-runs if they offer demand deposit contracts (and markets are incomplete)....
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...Gromb and Vayanos (2002) derive welfare results in a model in which arbitrageurs face margin constraints similar to those in our model....
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Book•

The econometrics of financial markets

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John Y. Campbell¹, Andrew W. Lo¹, A. Craig MacKinlay¹•Institutions (1)

Princeton University¹

01 Jan 1997

TL;DR: In this paper, Campbell, Lo, and MacKinlay present an attempt by three well-known and well-respected scholars to fill an acknowledged void in the empirical finance literature, a text covering the burgeoning field of empirical finance.

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Abstract: This book is an ambitious effort by three well-known and well-respected scholars to fill an acknowledged void in the literature—a text covering the burgeoning field of empirical finance. As the authors note in the preface, there are several excellent books covering financial theory at a level suitable for a Ph.D. class or as a reference for academics and practitioners, but there is little or nothing similar that covers econometric methods and applications. Perhaps the closest existing text is the recent addition to the Wiley Series in Financial and Quantitative Analysis. written by Cuthbertson (1996). The major difference between the books is that Cuthbertson focuses exclusively on asset pricing in the stock, bond, and foreign exchange markets, whereas Campbell, Lo, and MacKinlay (henceforth CLM) consider empirical applications throughout the field of finance, including corporate finance, derivatives markets, and market microstructure. The level of anticipation preceding publication can be partly measured by the fact that at least three reviews (including this one) have appeared since the book arrived. Moreover, in their reviews, both Harvey (1998) and Tiso (1998) comment on the need for such a text, a sentiment that has been echoed by numerous finance academics.

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7,169 citations

"Market liquidity and funding liquid..." refers background in this paper

...Empirically, fundamental volatility can be captured using price changes over a longer time period, and the total fundamental and liquidity-based volatility is captured by short-term price changes as in the literature on variance ratios (see e.g. Campbell, Lo, and MacKinlay (1997) )....
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Journal Article•DOI•

Bid, ask and transaction prices in a specialist market with heterogeneously informed traders

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Lawrence R. Glosten¹, Lawrence R. Glosten², Paul Milgrom³•Institutions (3)

Northwestern University¹, University of Chicago², Yale University³

01 Mar 1985-Journal of Financial Economics

TL;DR: The presence of traders with superior information leads to a positive bid-ask spread even when the specialist is risk-neutral and makes zero expected profits as discussed by the authors, and the expectation of the average spread squared times volume is bounded by a number that is independent of insider activity.

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5,902 citations

"Market liquidity and funding liquid..." refers background in this paper

...…be costly to trade — that is, has less than perfect market liquidity — because of exogenous order processing costs, private information (Kyle (1985) and Glosten and Milgrom (1985)), inventory risk of market makers (e.g. Stoll (1978), Ho and Stoll (1981,1983) Ho and Stoll (1981) and Grossman and…...
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...Holmström and Tirole’s (1998, 2001) research focuses primarily on funding liquidity. They show that corporations with agency problems have a preference for government bonds because they provide a cushion for future funding liquidity problems. Hence, government bonds trade at a premium. Our paper is also related to parts of the literature on the “limits to arbitrage.”(17) Shleifer and Vishny (1997) show, among other things, that a demand shock can be amplified if losses lead to withdrawal of capital from fund managers. We show that a similar effect can arise due to leverage and document how the multiplier is exacerbated by the degree of leverage (Proposition 2) and that this funding effect can lead to fragility (Proposition 1). Liu and Longstaff (2004) derive the optimal dynamic arbitrage strategy under funding constraints in a setting with an exogenous price process....
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...Holmström and Tirole’s (1998, 2001) research focuses primarily on funding liquidity. They show that corporations with agency problems have a preference for government bonds because they provide a cushion for future funding liquidity problems. Hence, government bonds trade at a premium. Our paper is also related to parts of the literature on the “limits to arbitrage.”(17) Shleifer and Vishny (1997) show, among other things, that a demand shock can be amplified if losses lead to withdrawal of capital from fund managers....
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