Robust and Interpretable Liquidity Proxies for Market and Funding Liquidity

Abstract

We introduce a method to create two interpretable liquidity measures, which we associate with market and funding liquidity. The construction is based on creating two parsimonious linear combinations of the many liquidity proxies often used in the liquidity literature, both displaying mean-reverting behavior, but characterized by very different reversion speeds. Our construction does not require transaction-level data (such as volume or bid-offer spreads), but correlates well both with other measure that do, and with other liquidity proxies (liquidity as ‘noise’, liquidity as broker-dealer leverage) recently introduced in the literature. TOPICS:Fixed income and structured finance, Statistical methods, risk management Key Findings • We introduce two interpretable liquidity measures that can be obtained from publicly available prices, and correlate well with liquidity measures that require transaction-level information. • Our measures have distinct reversion speeds, which sort and mirror the different reversion speeds of the input liquidity proxies. • We interpret our measures as relating to market and funding liquidity, and we justify this interpretation. • We present a brief application (to the extraction of inflation expectations from the break-even yield) to give an idea of how our measures can be used.