Posted Content•
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
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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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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
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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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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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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TL;DR: In this article, the authors used a randomly drawn sample of 314 over-the-counter stocks and found that while there are economies of scale, they are not on the dealer level, both systematic and unsystematic risk were tested for association with transaction costs in this market.
625 citations
"Market liquidity and funding liquid..." refers background or result in this paper
...Next, our model predicts that market liquidity declines as fundamental volatility increases, which is consistent with the empirical findings of Benston and Hagerman (1974) and Amihud and Mendelson (1989)....
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...Next, our model predicts that market liquidity declines with fundamental volatility, which is consistent with the empirical findings of Benston and Hagerman (1974) and Amihud and Mendelson (1989)....
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...Empirically, a relation between market liquidity and volatility has been documented by Benston and Hagerman (1974) and Amihud and Mendelson (1989), and flight to liquidity has been documented by Acharya and Pedersen (2005)....
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...Empirically, a relation between market liquidity and volatility has been documented by Benston and Hagerman (1974) and Amihud and Mendelson (1989), and flight to liquidity has been documented by Acharya and Pedersen (2005)....
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Book•
01 Jan 2007TL;DR: In this article, the authors discuss the history and institutions, time, uncertainty and liquidity of financial markets, and the fragility of financial fragility in the context of bubble and crisis.
Abstract: 1. History and institutions 2. Time, uncertainty and liquidity 3. Intermediation 4. Asset markets 5. Financial fragility 6. Intermediation and markets 7. Optimal regulation 8. Money and the prices 9. Bubbles and crises 10. Contagion
611 citations
Posted Content•
TL;DR: In this article, the authors model the demand-pressure effect on prices when options cannot be perfectly hedged and show that demand pressure in one option contract increases its price by an amount proportional to the variance of the unhedgeable part of the option.
Abstract: We model the demand-pressure effect on prices when options cannot be perfectly hedged The model shows that demand pressure in one option contract increases its price by an amount proportional to the variance of the unhedgeable part of the option Similarly, the demand pressure increases the price of any other option by an amount proportional to the covariance of their unhedgeable parts Empirically, we identify aggregate positions of dealers and end users using a unique dataset, and show that demand-pressure effects contribute to well-known option-pricing puzzles Indeed, time-series tests show that demand helps explain the overall expensiveness and skew patterns of both index options and single-stock options
588 citations
Posted Content•
TL;DR: In this article, the authors distinguish financial intermediaries according to whether they issue complete contingent contracts or incomplete contracts, and they argue that there may be a role for regulating liquidity provision in an economy in which markets for aggregate risks are incomplete.
Abstract: A complex financial system comprises both financial markets and financial intermediaries. We distinguish financial intermediaries according to whether they issue complete contingent contracts or incomplete contracts. Intermediaries such as banks that issue incomplete contracts, e.g., demand deposits, are subject to runs, but this does not imply a market failure. A sophisticated financial system a system with complete markets for aggregate risk and limited market participation is incentive-efficient, if the intermediaries issue complete contingent contracts, or else constrained-efficient, if they issue incomplete contracts. We argue that there may be a role for regulating liquidity provision in an economy in which markets for aggregate risks are incomplete.
585 citations
TL;DR: In this article, the authors jointly estimate the effects of four factors on stock returns, namely, risk, residual risk, size, and public availability of information about assets, and conclude that asset returns are determined solely by the systematic (3) risk.
Abstract: Merton's [26] recent extension of the CAPM proposed that asset returns are an increasing function of their beta risk, residual risk, and size and a decreasing function of the public availability of information about them. Associating the latter with asset liquidity and following Amihud and Mendelson's [2] proposition that asset returns increase with their illiquidity (measured by the bid-ask spread), we jointly estimate the effects of these four factors on stock returns. ACCORDING TO THE CAPITAL Asset Pricing Model (CAPM), expected asset returns are determined solely by the systematic (3) risk. Inconsistencies between the dictum of the theory and the empirical findings led Merton [26] to suggest a more general model of asset pricing, assuming that each investor has information only about a subset of the available assets and composes his or her portfolio only of this subset. The resulting portfolio will differ from the CAPM portfolio, and the expected return on each asset will be as follows: (i) an increasing function of its systematic (d) risk; (ii) an increasing function of its residual risk (due to imperfect diversification of this risk);
556 citations