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Market liquidity and funding liquidity

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 ArticleDOI
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 ArticleDOI
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 ChapterDOI
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 ArticleDOI
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 ArticleDOI
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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Journal ArticleDOI
TL;DR: In this article, the authors describe financial contagion as a wealth effect in a continuous-time model with two risky assets and three types of traders, i.e., convergence traders with logarithmic utility trade optimally in both markets, while noise traders trade randomly in one market.
Abstract: Financial contagion is described as a wealth effect in a continuous-time model with two risky assets and three types of traders. Noise traders trade randomly in one market. Long-term investors provide liquidity using a linear rule based on fundamentals. Convergence traders with logarithmic utility trade optimally in both markets. Asset price dynamics are endogenously determined ~numerically! as functions of endogenous wealth and exogenous noise. When convergence traders lose money, they liquidate positions in both markets. This creates contagion, in that returns become more volatile and more correlated. Contagion reduces benefits from portfolio diversification and raises issues for risk management. DURING THE F INANCIAL PANIC ASSOCIATED with the default of the Russian government in August 1998 and the subsequent collapse of the hedge fund Long Term Capital Management, numerous hedge funds, banks, and securities firms tried simultaneously to reduce exposures to a variety of financial instruments, such as Russian bonds, Brazilian stocks, U.S. mortgages, spreads between on-therun and off-the-run government securities, and spreads between swaps and U.S. Treasuries. Although the fundamental values of these positions would appear to have little correlation, during this financial crisis, the asset prices in these markets exhibited the following common empirical pattern: 1. Financial intermediaries suffered losses as prices moved against their positions; 2. Market depth and liquidity decreased simultaneously in several markets; 3. The volatility of prices increased simultaneously in several markets; and,

902 citations


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

  • ...Our commonality results can also be related to certain work on contagion (see e.g. Allen and Gale (2000), Kyle and Xiong (2001), and Brunnermeier and Pedersen (2005))....

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  • ...Most directly related are the models with margin-constrained traders, including Liu and Longstaff (2004) who derive optimal strategies in a partial equilibrium with a single security, and Gromb and Vayanos (2002) who derive a general equilibrium with one security and study welfare and liquidity provision....

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Posted Content
TL;DR: In this paper, the authors investigated the importance of cross-stock common factors in the price discovery/liquidity provision process in equity markets and found that both returns and order flows are characterized by common factors.
Abstract: How important are cross-stock common factors in the price discovery/liquidity provision process in equity markets? We investigate two aspects of this question for the thirty Dow stocks. First, using principal components and canonical correlation analyses we find that both returns and order flows are characterized by common factors. Commonality in the order flows explains roughly half of the commonality in returns. Second, we examine variation and common covariation in various liquidity proxies and market depth (trade impact) coefficients. Liquidity proxies such as the bid-ask spread and bid-ask quote sizes exhibit time variation which helps explain time variation in trade impacts. The common factors in these liquidity proxies are relatively small, however.

857 citations


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

  • ...The market liquidity literature shows that 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....

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  • ...Empirically, Chordia, Roll, and Subrahmanyam (2000), Hasbrouck and Seppi (2001) and Huberman and Halka (2001) document that there is commonality of stocks’ market liquidity, that is, market liquidity is correlated across stocks.13 Our model shows that this commonality in market liquidity can be…...

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  • ...This may help explain why market liquidity is correlated across stocks (Chordia, Roll, and Subrahmanyam (2000), Hasbrouck and Seppi (2001) and Huberman and Halka (2001)), and across stocks and bonds (Chordia, Sarkar, and Subrahmanyam (2005))....

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Journal ArticleDOI
TL;DR: In this paper, the authors propose a multi-period model in which competitive arbitrageurs exploit discrepancies between the prices of two identical risky assets, traded in segmented markets, and characterize conditions under which arbitrageur take too much or too little risk.
Abstract: We propose a multi-period model in which competitive arbitrageurs exploit discrepancies between the prices of two identical risky assets, traded in segmented markets. Arbitrageurs need to collateralize separately their positions in each asset, and this implies a financial constraint limiting positions as a function of wealth. In our model, arbitrage activity benefits all investors because arbitrageurs supply liquidity to the market. However, arbitrageurs may fail to take a socially optimal level of risk, in the sense that a change in their positions may make all investors better off. We characterize conditions under which arbitrageurs take too much or too little risk.

832 citations

Posted Content
TL;DR: In this article, the authors address a basic, yet unresolved question: Do claims on private assets provide sufficient liquidity for an efficient functioning of the productive sector? Or does the State have a role in creating liquidity and regulating it either through adjustments in the stock of government securities or by other means?
Abstract: This paper addresses a basic, yet unresolved question : Do claims on private assets provide sufficient liquidity for an efficient functioning of the productive sector? Or does the State have a role in creating liquidity and regulating it either through adjustments in the stock of government securities or by other means?

826 citations

Journal ArticleDOI
TL;DR: In this paper, the behavior of competing dealers in securities markets is analyzed and the conditions for interdealer trading are specified, and the equilibrium distribution of dealer inventories and equilibrium market spread are derived.
Abstract: The behavior of competing dealers in securities markets is analyzed. Securities are characterized by stochastic returns and stochastic transactions. Reservation bid and ask prices of dealers are derived under alternative assumptions about the degree to which transactions are correlated across stocks at a given time and over time in a given stock. The conditions for interdealer trading are specified, and the equilibrium distribution of dealer inventories and the equilibrium market spread are derived. Implications for the structure of securities markets are examined. IN THIS PAPER the behavior of competing dealers in security markets is examined. Much of the theoretical work on dealers (Demsetz [6], Tinic [18], Garman [8], Stoll [16], Amihud and Mendelson [1], Ho and Stoll [11], Copeland and Galai [3], Mildenstein and Schleef [13]) has recognized that dealers may face competition from other dealers or investors placing limit orders, but nonetheless has analyzed only a single (representative) dealer. This approach is quite reasonable for the New York Stock Exchange specialist who has a quasi-monopoly position, but it is less applicable when considering other markets such as the over-thecounter market where there are several dealers with equal access to the market. Similarly the empirical studies of dealer bid-ask spreads (Demsetz [6], Tinic [18], Tinic and West [19], Benston and Hagerman [2], Stoll [17], Smidt [15]) have either been based on models of a single dealer or have lacked a theoretical foundation based on the microeconomics of the dealer. This paper develops a theoretical model of equilibrium in a market with competing dealers and provides a basis for empirical work that would distinguish competing and monopolistic dealer markets. The paper is concerned with the behavior and interaction of individual competing dealers and with the determination of the market bid-ask spread. Markets with several dealers, several stocks and several periods are considered. Dealers bear risk arising not only from uncertainty about the returns on their inventories but also from uncertainty about the arrival of transactions. Each dealer also recognizes that his welfare depends on the actions of other dealers and each sets bid and ask prices to maximize his own expected utility of terminal wealth. A recent paper by Cohen, Maier, Schwartz and Whitcomb [5] examines similar issues in the context of an auction market in which the market spread is determined by limit orders. However, unlike the model of this paper, their analysis is not based as clearly on a model of individual traders' maximizing behaviors nor are the costs of placing * Financial support of the Dean's Fund for Faculty Research at the Owen Graduate School of

818 citations