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Market liquidity and funding liquidity

Markus K. Brunnermeier1, Lasse Heje Pedersen2•
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.
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
Citations
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Journal Article•DOI•
Deciphering the Liquidity and Credit Crunch 2007-08

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Markus K. Brunnermeier1•
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.
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.

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•
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.
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.

1,950 citations

Book Chapter•DOI•
Financial Intermediation and Credit Policy in Business Cycle Analysis

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Mark Gertler1, Nobuhiro Kiyotaki1•
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.
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.

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.
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.

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.
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.

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•
Leverage and Market Stability: The Role of Margin Rules and Price Limits

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Bhagwan Chowdhry1, Bhagwan Chowdhry2, Vikram K. Nanda3•
Indian School of Business1, University of California, Los Angeles2, University of Texas at Dallas3
21 May 1998-Social Science Research Network
TL;DR: In this article, the authors explore the effects of market composition and market trading rules on the stability of the market and show that when some investors hold levered portfolios by engaging in margin borrowing, repeated rounds of trading can result in market instability.
Abstract: We propose a simple model in which all agents are rational and symmetrically informed. We show that when some investors hold levered portfolios by engaging in margin borrowing, repeated rounds of trading can result in market instability -- in the sense that prices can move rationally, even in the absence of any change in fundamentals. We explore the effects of market composition and market trading rules on the stability of the market. Sufficiently large margin requirements are always associated with stability. Decreasing the margin requirements sufficiently may also ensure stability. A major result of the paper is that price limits might enhance market stability by excluding potentially destabilizing market prices. The tradeoffs involved in choosing an optimal combination of price limits and margin requirements to achieve market stability are analyzed. The possible role of specialists and price continuity rules in enhancing market stability are discussed.

106 citations

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

  • ...Our result on multiplicity due to dealer losses is 11We thank Markus Konz from the futures exchange EUREX for describing how margin requirements are set. similar to Chowdhry and Nanda (1998)....

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  • ...3 The loss spiral is related to the multipliers that arise in Grossman (1988); Kiyotaki and Moore (1997); Shleifer and Vishny (1997); Chowdhry and Nanda (1998); Xiong (2001); Kyle and Xiong (2001); Gromb and Vayanos (2002); Morris and Shin (2004); Plantin, Sapra, and Shin (2005); and others. In Geanakoplos (2003) and in Fostel and Geanakoplos (2008), margins increase as risk increases. Our paper captures the margin spiral—i.e., the adverse feedback loop between margins and prices—and the interaction between the margin and loss spirals. Garleanu and Pedersen (2007) show how a risk management spiral can arise....

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  • ...3 The loss spiral is related to the multipliers that arise in Grossman (1988); Kiyotaki and Moore (1997); Shleifer and Vishny (1997); Chowdhry and Nanda (1998); Xiong (2001); Kyle and Xiong (2001); Gromb and Vayanos (2002); Morris and Shin (2004); Plantin, Sapra, and Shin (2005); and others....

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  • ...Other models with margin-constrained traders are Grossman and Vila (1992) and Liu and Longstaff (2004), which derive optimal strategies in a partial equilibrium with a single security; Chowdhry and Nanda (1998) focus on fragility due to dealer losses; and Gromb and Vayanos (2002) derive a general equilibrium with one security (traded in two segmented markets) and study welfare and liquidity provision....

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  • ...3 The loss spiral is related to the multipliers that arise in Grossman (1988); Kiyotaki and Moore (1997); Shleifer and Vishny (1997); Chowdhry and Nanda (1998); Xiong (2001); Kyle and Xiong (2001); Gromb and Vayanos (2002); Morris and Shin (2004); Plantin, Sapra, and Shin (2005); and others. In Geanakoplos (2003) and in Fostel and Geanakoplos (2008), margins increase as risk increases....

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Journal Article•DOI•
Liquidity Risk and Correlation Risk: A Clinical Study of the General Motors and Ford Downgrade of May 2005

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Viral V. Acharya1, Stephen M. Schaefer2, Yili Zhang2•
New York University1, London Business School2
18 Nov 2007-Social Science Research Network
TL;DR: In this article, the GM and Ford downgrade to junk status during May 2005 caused a wide-spread selloff in their corporate bonds, which generated significant liquidity risk for market-makers, as evidenced in the significant imbalance in their quotes towards sales.
Abstract: The GM and Ford downgrade to junk status during May 2005 caused a wide-spread sell-off in their corporate bonds. Using a novel dataset, we document that this sell-off appears to have generated significant liquidity risk for market-makers, as evidenced in the significant imbalance in their quotes towards sales. We also document that simultaneously, there was excess co-movement in the fixed-income securities of all industries, not just in those of auto firms. In particular, using credit-default swaps (CDS) data, we find a substantial increase in the co-movement between innovations in the CDS spreads of GM and Ford and those of firms in all other industries, the increase being greatest during the period surrounding the actual downgrade and reversing sharply thereafter. We show that a measure of liquidity risk faced by corporate bond market-makers - specifically, the imbalance towards sales in the volume and frequency of quotes on GM and Ford bonds - explains a significant portion of this excess co-movement. Additional robustness checks suggest that this relationship between the liquidity risk faced by market-makers and the correlation risk for other securities in which they make markets was likely causal. Overall, the evidence is supportive of theoretical models which imply that funding liquidity risk faced by financial intermediaries is a determinant of market prices during stress times.

105 citations

Market Liquidity and Asset Prices under Costly Participation

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Jennifer Huang1, Jiang Wang2•
University of Texas at Austin1, Massachusetts Institute of Technology2
01 Jan 2005
TL;DR: Huang et al. as discussed by the authors developed an equilibrium model for market liquidity and its impact on asset prices when constant participation in the market is costly, and showed that the lack of coordination among investors in the demand and the supply of liquidity generates negative externalities, and the loss in social welfare can out-weight the savings on participation costs.
Abstract: In this paper, we develop an equilibrium model for market liquidity and its impact on asset prices when constant participation in the market is costly. We show that, even when investors’ trading needs are perfectly matched, costly participation prevents them from synchronize their trades, which gives rise to the need for liquidity in the market. Fluctuations in liquidity needs cause asset prices to deviate from the fundamentals. Moreover, these price deviations tend to have large magnitudes in absence of any aggregate shocks, resembling what can be called “liquidity crashes”, and lead to fat tails in return distributions. We also show that the lack of coordination among investors in the demand and the supply of liquidity generates negative externalities, and the loss in social welfare can out-weight the savings on participation costs. ∗The authors thank seminar participants at UT-Austin and HKUST for comments and suggestions. †Department of Finance, B6600, McCombs School of Business, The University of Texas at Austin, Austin, TX 78712. Email: jennifer.huang@mccombs.utexas.edu, tel: (512)232-9375, fax: (512)471-5073, and website: www.mccombs.utexas.edu/Faculty/Jennifer.Huang. ‡MIT Sloan School of Management, E52-456, 50 Memorial Drive, Cambridge, MA 02142-1347, CCFR and NBER. Email: wangj@mit.edu, tel: (617)253-2632, and fax: (617)258-6855.

19 citations

Journal Article•DOI•
Revisiting the October 1987 Crash

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Barrie A. Wigmore
01 Jan 1998-Financial Analysts Journal
TL;DR: The crash of 1987 reflected panic selling by the retail public, foreigners, and institutions in response to overvaluation, an effort by the U.S. Congress to restrict merger activity, rising interest rates, and international policy squabbles as discussed by the authors.
Abstract: The crash of 1987 reflected panic selling by the retail public, foreigners, and institutions in response to overvaluation, an effort by the U.S. Congress to restrict merger activity, rising interest rates, and international policy squabbles. Portfolio insurance overwhelmed the specialists, who were unable to handle the large index trades in the Designated Order Turnaround system. The credit crisis on the second day reflected justifiable worries about brokers' credit. With valuation and other indicators back to the record levels of 1987, could the U.S. market suffer a repeat of October 1987?

16 citations

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

  • ...(See SEC (1988) and Wigmore (1998).) In summary, our results on fragility and liquidity spirals imply that during “bad” times, small changes in underlying funding conditions (or liquidity demand) can lead to sharp reductions in liquidity....

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Trending Questions (1)
What is the deification of the availability of market support and funding?

Market liquidity and funding liquidity are interdependent in a model where traders' ability to provide market support relies on their access to funding, creating potential liquidity spirals.

See answers from 4 other papers