Understand funding liquidity and market liquidity in a regime‐switching model

Louisa Chen,Zhiping Zhou,Liya Shen

doi:10.1002/ijfe.2438

Abstract

AbstractWe investigate the time‐varying relationship of funding liquidity (FL) and market liquidity (ML) in a Markov regime‐switching model. By using a comprehensive U.S. TRACE dataset, we provide strong evidence that FL and corporate bond ML are interlinked, and their impact on each other is highly regime‐dependent. We find that FL and ML exhibit a large‐and‐positive mutual impact when money market is tight and equity market is volatile. But in normal regimes, FL is found to have a negative impact on ML with a much smaller magnitude than those in stressed regimes. Furthermore, FL is more stable than ML with less regime changes. Our article offers insight on the important mechanism by which central banks can improve ML through the funding market.

Highlights

Financial time series occasionally display dramatic breaks in their behaviour, due to, for example, financial crises
Our results show that funding liquidity and market liquidity have a large-and-positive mutual effect when money market is tight and bond market volatility is high, but this mutual effect is much smaller or insignificant in normal regimes
Inspired by the recent debates and theoretical development on funding liquidity and market liquidity, we investigate the time-varying relationship of funding liquidity and market liquidity

Summary

| INTRODUCTION

Financial time series occasionally display dramatic breaks in their behaviour, due to, for example, financial crises. This approach is suitable to capture complex dynamic patterns of the relationship between FL and ML, which features with nonlinear stationarity and structural breaks Through this approach, we add new findings to the literature (e.g., funding liquidity negatively influences market liquidity in normal times but this turns to be positive in stressed times). Our article is close to the empirical works of Boudt et al (2017) and Chung et al (2017) in which a linear framework is adopted in the analyses The former examines the effect of the bid-ask spread of S&P 500 index on stock loan rates, and the later examines the relationship between liquidity discount rate and the floating-rate bonds in the Japanese market.

| LITERATURE REVIEW AND HYPOTHESES

| Funding liquidity measures

| CONCLUSIONS AND IMPLICATIONS