Noise as Information for Illiquidity

Abstract

We propose a broad measure of liquidity for the overall financial market by exploiting its connection with the amount of arbitrage capital in the market and the potential impact on price deviations in US Treasurys. When arbitrage capital is abundant, we expect the arbitrage forces to smooth out the Treasury yield curve and keep the dispersion low. During market crises, the shortage of arbitrage capital leaves the yields to move more freely relative to the curve, resulting in more “noise.” As such, noise in the Treasury market can be informative and we expect this information about liquidity to reflect the broad market conditions because of the central importance of the Treasury market and its low intrinsic noise – high liquidity and low credit risk. Indeed, we find that our “noise” measure captures episodes of liquidity crises of different origins and magnitudes and is also related to other known liquidity proxies. Moreover, using it as a priced risk factor helps explain cross-sectional returns on hedge funds and currency carry trades, both known to be sensitive to the general liquidity conditions of the market.