Showing papers on "Funding liquidity published in 2008"

Carry Trades and Currency Crashes

Abstract: This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between high-interest-rate and low-interest-rate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which risk appetite and funding liquidity decrease. Funding liquidity measures predict exchange rate movements, and controlling for liquidity helps explain the uncovered interest-rate puzzle. Carry-trade losses reduce future crash risk, but increase the price of crash risk. We also document excess co-movement among currencies with similar interest rate. Our findings are consistent with a model in which carry traders are subject to funding liquidity constraints.

Carry Trades and Currency Crashes

Abstract: This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between high-interest-rate and low-interest-rate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which risk appetite and funding liquidity decrease. Funding liquidity measures predict exchange rate movements, and controlling for liquidity helps explain the uncovered interest-rate puzzle. Carry-trade losses reduce future crash risk, but increase the price of crash risk. We also document excess co-movement among currencies with similar interest rate. Our flndings are consistent with a model in which carry traders are subject to funding liquidity constraints.

Transmission of Liquidity Shocks: Evidence from the 2007 Subprime Crisis

Abstract: We examine the linkages between market and funding liquidity pressures, as well as their interaction with solvency issues surrounding key financial institutions during the 2007 subprime crisis. A multivariate GARCH model is estimated in order to test for the transmission of liquidity shocks across U.S. financial markets. It is found that the interaction between market and funding illiquidity increases sharply during the recent period of financial turbulence, and that bank solvency becomes important.

Transmission of Liquidity Shocks; Evidence from the 2007 Subprime Crisis

Abstract: We examine the linkages between market and funding liquidity pressures, as well as their interaction with solvency issues surrounding key financial institutions during the 2007 subprime crisis. A multivariate GARCH model is estimated in order to test for the transmission of liquidity shocks across U.S. financial markets. It is found that the interaction between market and funding illiquidity increases sharply during the recent period of financial turbulence, and that bank solvency becomes important.

Liquidity production in 21st century banking

Abstract: I consider banks' role in providing funding liquidity (the ability to raise cash on demand) and market liquidity (the ability to trade assets at low cost), and how these roles have evolved. Traditional banks made illiquid loans funded with liquid deposits, thus producing funding liquidity on the liability side of the balance sheet. Deposits are less important in 21st century banks, but funding liquidity from lines of credit and loan commitments has become more important. Banks also provide market liquidity as broker-dealers and traders in securities and derivatives markets, in loan syndication and sales, and in loan securitization. Many institutions besides banks provide market liquidity in similar ways, but banks dominate in producing funding liquidity because of their comparative advantage in managing funding liquidity risk. This advantage stems from the structure of bank balance sheets as well as their access to government-guaranteed deposits and central-bank liquidity.

Investors’ Risk Appetite and Global Financial Market Conditions

Abstract: A structural vector autoregression model is developed to analyze the dynamics of bond spreads among a sample of mature and developing countries during periods of financial stress in the last decade. The model identifies and quantifies the contribution on bond spreads from global market conditions (including funding liquidity, market liquidity, as well as credit and volatility risks), contagion effects, and idiosyncratic factors. While idiosyncratic factors explain a large amount of the changes in bond spreads over the sample, global market risk factors are fundamental driving forces during periods of stress. The relative importance of the different risk factors changes substantially depending on the crisis episode. Contagion from emerging markets becomes small or non-existent when global financial market risks explicitly are taken into account.

Hedge Fund Contagion and Liquidity

Abstract: Using hedge fund indices representing eight different styles, we find strong evidence of contagion within the hedge fund sector: controlling for a number of risk factors, the average probability that a hedge fund style index has extreme poor performance (lower 10% tail) increases from 2% to 21% as the number of other hedge fund style indices with extreme poor performance increases from zero to seven. We investigate how changes in funding and asset liquidity intensify this contagion, and find that the likelihood of contagion is high when prime brokerage firms have poor performance (which would be expected to affect hedge fund funding liquidity adversely) and when stock market liquidity (a proxy for asset liquidity) is low. Finally, we examine whether extreme poor performance in the stock, bond, and currency markets is more likely when contagion in the hedge fund sector is high. We find no evidence that contagion in the hedge fund sector is associated with extreme poor performance in the stock and bond markets, but find significant evidence that performance in the currency market is worse when hedge fund contagion is high, consistent with the effects of an unwinding of carry trades.

Investors Risk Appetite and Global Financial Market Conditions

Abstract: A structural vector autoregression model is developed to analyze the dynamics of bond spreads among a sample of mature and developing countries during periods of financial stress in the last decade. The model identifies and quantifies the contribution on bond spreads from global market conditions (including funding liquidity, market liquidity, as well as credit and volatility risks), contagion effects, and idiosyncratic factors. While idiosyncratic factors explain a large amount of the changes in bond spreads over the sample, global market risk factors are fundamental driving forces during periods of stress. The relative importance of the different risk factors changes substantially depending on the crisis episode. Contagion from emerging markets becomes small or non-existent when global financial market risks explicitly are taken into account.

Moral Hazard, Collateral and Liquidity

Abstract: We consider a moral hazard setup wherein leveraged firms have incentives to take on excessive risks and are thus rationed when they attempt to borrow in order to meet liquidity shocks. The rationed firms can optimally pledge cash as collateral to borrow more, but in the process must liquidate some of their assets. Liquidated assets are purchased by non-rationed firms but their borrowing capacity is also limited by the moral hazard. The market-clearing price exhibits cash-in-the-market pricing and depends on the entire distribution of liquidity shocks in the economy. As moral hazard intensity varies, equilibrium price and level of collateral requirements are negatively related. However, compared to models where collateral requirements are exogenously specified, the endogenously designed collateral in our model has a stabilizing role on prices: For any given intensity of moral hazard problem, asset sales are smaller in quantity, and, in turn, equilibrium price is higher, when collateral requirements are optimally designed. This price-stabilizing role implies that the ex-ante debt capacity of firms is higher with collateral and thereby ex-post liability shocks are smaller. This stabilizes prices further, resulting in an important feedback: Collateral reduces the proportion of ex-ante rationed firms and thus leads to greater market participation. Our model provides an agency-theoretic explanation for some features of financial crises such as the linkage between market and funding liquidity and deep discounts observed in prices during crises that follow good times.

Liquidity in global markets

Abstract: The latest episode of turbulence has been marked by an extended period of illiquidity in a large number of markets –ranging from traditionally highly liquid interbank money markets to the less-liquid structured credit markets. The event began with what was widely perceived as a credit deterioration in the US subprime mortgage market. However, this quickly raised uncertainty about the valuation of securities related to this market, thus affecting their liquidity. The rapidity with which this market illiquidity has been transmitted into funding illiquidity has been both striking and unprecedented. The event has raised questions about how market liquidity in a variety of instruments is determined in both primary and secondary markets and how mechanisms act to transmit illiquidity across markets during a period of stress. The article seeks to identify how standard concepts of liquidity can be applied to various types of markets across the globe with a view to interpreting how liquidity deteriorated so quickly. Several attributes of liquidity –types of market structures (including existence of formal intermediaries and trading venues), the construction of the instruments, and the types of investors– are used to guide the analysis. One feature that appears to be important for liquidity is the degree to which information about the risks underlying the financial instrument are well understood by both buyers and sellers. Another insight is that the expectations of market participants about liquidity and their ability to monitor it also have an impact on liquidity itself. These attributes suggest that the growth in securitization and complex structured credit products –new developments in the transfer of credit risk– may carry with them a predilection to adverse liquidity events that will require further examination. In light of the analysis, the article identifies ways of mitigating some of the problems that arose in this latest bout of illiquidity. Because liquidity is created and maintained by the market participants themselves, most of the room for improvement rests with the private sector. It is already clear that some market practices and policies will need to change and in this context some suggestions for enhancements to financial institutions’ liquidity risk management are outlined. However, given that both market and funding liquidity are intimately related to financial stability, a public good, there is also a potential role for the public sector. Hence, the tools used by central banks to maintain their role in effi cient monetary policy transmission together with financial stability will need to be reviewed.

Liquidity Production in 21st Century Banking

Abstract: I consider banks' role in providing funding liquidity (the ability to raise cash on demand) and market liquidity (the ability to trade assets at low cost), and how these roles have evolved. Traditional banks made illiquid loans funded with liquid deposits, thus producing funding liquidity on the liability side of the balance sheet. Deposits are less important in 21st century banks, but funding liquidity from lines of credit and loan commitments has become more important. Banks also provide market liquidity as broker-dealers and traders in securities and derivatives markets, in loan syndication and sales, and in loan securitization. Many institutions besides banks provide market liquidity in similar ways, but banks dominate in producing funding liquidity because of their comparative advantage in managing funding liquidity risk. This advantage stems from the structure of bank balance sheets as well as their access to government-guaranteed deposits and central-bank liquidity.

Hedge Fund Contagion and Liquidity

Abstract: Using hedge fund indices representing eight different styles, we find strong evidence of contagion within the hedge fund sector: controlling for a number of risk factors, the average probability that a hedge fund style index has extreme poor performance (lower 10% tail) increases from 2% to 21% as the number of other hedge fund style indices with extreme poor performance increases from zero to seven. We investigate how changes in funding and asset liquidity intensify this contagion, and find that the likelihood of contagion is high when prime brokerage firms have poor performance (which would be expected to affect hedge fund funding liquidity adversely) and when stock market liquidity (a proxy for asset liquidity) is low. Finally, we examine whether extreme poor performance in the stock, bond, and currency markets is more likely when contagion in the hedge fund sector is high. We find no evidence that contagion in the hedge fund sector is associated with extreme poor performance in the stock and bond markets, but find significant evidence that performance in the currency market is worse when hedge fund contagion is high, consistent with the effects of an unwinding of carry trades.

Liquidity Stress-Tester: A macro model for stress-testing banks' liquidity risk

Abstract: This paper presents a macro stress-testing model for market and funding liquidity risks of banks, which have been main drivers of the recent financial crisis. The model takes into account the first and second round (feedback) effects of shocks, induced by behavioural reactions of heterogeneous banks, and idiosyncratic reputation effects. The impact on liquidity risk is simulated by a Monte Carlo approach. This generates distributions of liquidity buffers for each scenario round, including the probability of a liquidity shortfall. An application to Dutch banks illustrates that the second round effects have more impact than the first round effects and hit all types of banks, indicative of systemic risk. This lends support policy initiatives to enhance banks' liquidity buffers and liquidity risk management, which could also contribute to prevent financial stability risks.

Why do hedge funds' worst returns cluster? Common liquidity shocks vs. contagion

Abstract: Using monthly hedge fund style indices representing eight different styles from January 1990 to August 2007, we find strong evidence of clustering of worst returns. Controlling for hedge fund risk factors identified in the literature, the average probability that a hedge fund style index has a worst return (lower 10% tail) increases from 2% to 19% as the number of other hedge fund style indices with worst returns increases from zero to seven. We investigate possible explanations for this clustering. Adverse shocks to asset and funding liquidity increase sharply the likelihood of simultaneous worst returns across hedge fund styles in the same month and in the next month. Specifically, large adverse shocks to credit spreads, prime broker stock prices, stock market liquidity, repo volume, and hedge fund flows are associated with an economically significant increase in the probability of clustering of worst returns. Though contagion is a possible explanation for the clustering we observe, we find at best mixed support for this explanation.

Transmission of Liquidity Shocks : Evidence from the 2007 Subprime Crisis

Abstract: We examine the linkages between market and funding liquidity pressures, as well as their interaction with solvency issues surrounding key financial institutions during the 2007 subprime crisis. A multivariate GARCH model is estimated in order to test for the transmission of liquidity shocks across U.S. financial markets. It is found that the interaction between market and funding illiquidity increases sharply during the recent period of financial turbulence, and that bank solvency becomes important.

Charles A. Dice Center for Research in Financial Economics Why do Hedge Funds’ Worst Returns Cluster? Common Liquidity Shocks vs. Contagion

Abstract: Using monthly hedge fund style indices representing eight different styles from January 1990 to August 2007, we find strong evidence of clustering of worst returns. Controlling for hedge fund risk factors identified in the literature, the average probability that a hedge fund style index has a worst return (lower 10% tail) increases from 2% to 19% as the number of other hedge fund style indices with worst returns increases from zero to seven. We investigate possible explanations for this clustering. Adverse shocks to asset and funding liquidity increase sharply the likelihood of simultaneous worst returns across hedge fund styles in the same month and in the next month. Specifically, large adverse shocks to credit spreads, prime broker stock prices, stock market liquidity, repo volume, and hedge fund flows are associated with an economically significant increase in the probability of clustering of worst returns. Though contagion is a possible explanation for the clustering we observe, we find at best mixed support for this explanation. ∗ Boyson is at Northeastern University, Stahel is at George Mason University, and Stulz is at The Ohio State University, NBER, and ECGI. Corresponding author is Boyson: n.boyson@neu.edu, (617) 373-4775. We wish to thank Stephen Brown, William Greene, David Hsieh, Andrew Karolyi, Marno Verbeek, and participants at seminars and conferences at the CREST-Banque de France conference on contagion, the FDIC, Maastricht University, the Ohio State University, RSM Erasmus University, and Wharton for useful discussions. We are also grateful to Rose Liao and Jerome Taillard for research assistance. We thank Lisa Martin at Hedge Fund Research for assistance regarding her firm’s products. All remaining errors are our own.

Moral Hazard, Collateral and Liquidity

Abstract: We consider a moral hazard setup wherein leveraged firms have incentives to take on excessive risks and are thus rationed when they attempt to borrow in order to meet liquidity shocks. The rationed firms can optimally pledge cash as collateral to borrow more, but in the process must liquidate some of their assets. Liquidated assets are purchased by non-rationed firms but their borrowing capacity is also limited by the moral hazard. The market-clearing price exhibits cash-in-the-market pricing and depends on the entire distribution of liquidity shocks in the economy. As moral hazard intensity varies, equilibrium price and level of collateral requirements are negatively related. However, compared to models where collateral requirements are exogenously specified, the endogenously designed collateral in our model has a stabilizing role on prices: For any given intensity of moral hazard problem, asset sales are smaller in quantity, and, in turn, equilibrium price is higher, when collateral requirements are optimally designed. This price-stabilizing role implies that the ex-ante debt capacity of firms is higher with collateral and thereby ex-post liability shocks are smaller. This stabilizes prices further, resulting in an important feedback: Collateral reduces the proportion of ex-ante rationed firms and thus leads to greater market participation. Our model provides an agency-theoretic explanation for some features of financial crises such as the linkage between market and funding liquidity and deep discounts observed in prices during crises that follow good times.

Leveraged Liquidity: Bear Raids and Junk Loans in the New Credit Market

Abstract: As instability in the credit market has spread from sub-prime mortgages to commercial sectors, demand grows for a cogent account of current liquidity dynamics and their implications. To that end, I distinguish between market and funding liquidity and analyze how these distinct forms of liquidity contributed to financial instability in the corporate leverage market since July 2007. After introducing the major themes in terms accessible to a nonfinancial reader, I draw on economist Hyman Minsky's work on financial instability to analyze the liquidity dynamics of leverage cycles. In particular, I focus on four shifts in credit market structure that are vexing financial market regulators: the rise of nonbank lenders, the growth of floating-rate debt; the 'marketization' of corporate credit; and the attitude shifts that come with financial euphoria. I then zero in on the corporate version of sub-prime borrowing that many U.S. corporations used to finance the recent wave of mergers, acquisitions, and other types of "shareholder-friendly" transactions: leveraged loans. These are secured, sub-investment-grade, floating-rate loans priced off LIBOR, an asset class that corelates most closely with junk bonds. I conclude with recommendations for how regulatory and financial models can better reflect the new realities of the credit market.

Hedge Fund Contagion and Liquidity

Abstract: Using hedge fund indices representing eight different styles, we find strong evidence of contagion within the hedge fund sector: controlling for a number of risk factors, the average probability that a hedge fund style index has extreme poor performance (lower 10% tail) increases from 2% to 21% as the number of other hedge fund style indices with extreme poor performance increases from zero to seven. We investigate how changes in funding and asset liquidity intensify this contagion, and find that the likelihood of contagion is high when prime brokerage firms have poor performance (which would be expected to affect hedge fund funding liquidity adversely) and when stock market liquidity (a proxy for asset liquidity) is low. Finally, we examine whether extreme poor performance in the stock, bond, and currency markets is more likely when contagion in the hedge fund sector is high. We find no evidence that contagion in the hedge fund sector is associated with extreme poor performance in the stock and bond markets, but find significant evidence that performance in the currency market is worse when hedge fund contagion is high, consistent with the effects of an unwinding of carry trades.

Investors’ Risk Appetite and Global Financial Market Conditions

Abstract: A structural vector autoregression model is developed to analyze the dynamics of bond spreads among a sample of mature and developing countries during periods of financial stress in the last decade. The model identifies and quantifies the contribution on bond spreads from global market conditions (including funding liquidity, market liquidity, as well as credit and volatility risks), contagion effects, and idiosyncratic factors. While idiosyncratic factors explain a large amount of the changes in bond spreads over the sample, global market risk factors are fundamental driving forces during periods of stress. The relative importance of the different risk factors changes substantially depending on the crisis episode. Contagion from emerging markets becomes small or non-existent when global financial market risks explicitly are taken into account.

Discussion of 'The Unfolding Turmoil of 2007–2008: Lessons and Responses'

Abstract: The paper by Ben Cohen and Eli Remolona provides an excellent summary of the origins of the crisis. I agree with their emphasis on three key factors. There was: (a) fi nancial innovation – with exceptional opacity of new instruments; (b) low interest rates globally, which prompted a search for yield; and (c) an environment of ‘ravenous’ risk appetites driven by problematic incentives in various guises. The authors state that as credit risk problems became apparent, they transformed into a liquidity event, leading to what they claim to be the unique depth and duration of this crisis. The key to this is the interaction between market liquidity and funding liquidity in the context of maturity mismatch, with the potential for multiple adverse liquidity spirals as laid out by Brunnermeier (forthcoming).