Funding Liquidity Constraints Research Articles

Macro-Finance Models with Nonlinear Dynamics

We review macro-finance models featuring nonlinear dynamics that have recently been developed in the literature, including models with funding liquidity constraints, market liquidity frictions, and bank run frictions, and discuss the empirical evidence and challenges of this class of models. We also construct an illustrative model featuring financial frictions and nonlinear dynamics for readers who are unfamiliar with the literature. We solve the model using different solution techniques, including both global and perturbation solution methods, and comprehensively compare the accuracy of these solutions. Within this framework, we highlight that local linearization approximations omit important nonlinear dynamics and yield biased impulse responses.

Long-term reversals in the corporate bond market

Long-term reversals in corporate bonds are economically and statistically significant in a comprehensive sample spanning the period 1977 to 2017. Such reversals are stronger for bonds with high credit risk and more binding regulatory, capital, and funding liquidity constraints. Bond long-term reversal is not a manifestation of the equity counterpart and is mainly driven by long-term losers. A long-term reversal factor carries a sizable premium and is not explained by long-established equity and bond market factors. Thus, past returns capture investors’ ex-ante risk assessment and the degree of institutional constraints they face, so losing bonds command higher expected returns.

Liquidity Shocks in the Secondary Corporate Loan Market

This article examines the influence of liquidity risk on the U.S. secondary corporate loan market (herein loan market). The authors empirically disentangle the impact of both loan-level liquidity shocks and systematic liquidity risk from default risk. Loans that experience shocks to either liquidity or default risk experience ongoing price declines, complementing evidence presented elsewhere of price momentum in loan markets. The prices of loans with high liquidity risk are significantly discounted when market liquidity is low, consistent with the time-varying funding liquidity constraints of financial intermediaries. In keeping with a close link between high risk debt markets and equity markets, there is evidence that equity market risk is priced in the loan market.

FUNDING LIQUIDITY RISK, SYNDICATION BEHAVIOR AND THE RISK CULTURE OF THE AUSTRALIAN VENTURE CAPITAL INDUSTRY

Venture capital (VC) is usually invested in high risk technology companies at their early stages of development. In response to the industry risk environment, the VC fund managers have developed a set of risk management practices appropriate for the industry which include investment syndication. Furthermore, the VC funds are supplied by individual and institutional investors with different risk profiles and investment focus, usually in finite amounts and for a limited period of time. The funding agreement between the VC firms and the fund investors combined with the limited amount and time can lead to additional funding liquidity risks as the VC funds are invested in the portfolio companies. In this paper, we develop a simple two period model from a VC firm’s perspective with funding liquidity constraints to demonstrate how funding liquidity risk can influence syndication decisions. We subsequently analyze the implication of the model, derive a set of predictions and validate them with VC investment data from Australia. The analysis shows that syndication has both instrumental function in risk management and behavioral implications on risk culture essential for addressing the emerging frontiers of sustainability risks.

Hedge Fund Ownership, Funding Liquidity Constraints and Excess Return Co-Movement

This paper examines the funding liquidity faced by hedge funds and the resulting implication for stocks’ excess return co-movement. We find that hedge fund ownership tends to induce a higher stocks’ return co-movement with each other, compared to other institutional investors like mutual funds and pension funds. By exploring our sample into different periods, we show that the effect of excess return co-movement is much stronger during tight funding periods, which is consistent with price pressure due to flow-induced correlated trading by hedge funds. We further develop the cross-stock reversal trading strategy proposed by Anton and Polk (2014) and find significant abnormal return if we use the portfolio return of connected stocks held in common by hedge funds as a confirming signal. In particular, this trading strategy exploiting such price pressure due to common hedge fund ownership delivers a monthly alpha of 0.3%, which reaches 1.5% over the periods of funding liquidity constraints.

The role of covered interest parity in explaining the forward premium anomaly within a nonlinear panel framework

This paper investigates the dynamic properties of uncovered interest parity (UIP) depending on deviations from covered interest parity (CIP) in a nonlinear panel framework. By employing a panel smooth transition regression model, the threshold level of the CIP deviation in which UIP tends to hold is found to be outside the band of inaction where deviations from CIP would fail to be arbitraged away. This paper shows how reversals of UIP observed during the global financial crisis can be, to some extent, accounted for by funding liquidity constraints. Simulation experiments also suggest that the data-generating process from the nonlinear panel model can produce data consistent with the failure of UIP.

Funding liquidity constraints and the forward premium anomaly in a DSGE model

This paper investigates the role of a funding liquidity constraint in the forward premium anomaly by developing a two-sector, two-agent dynamic stochastic general equilibrium (DSGE) model. We show that international consumption risks are not perfectly shared owing to the presence of a funding constraint and various discount factors. We explicitly specify a risk premium term and measure it in response to negative productivity shocks, policy shocks, and exchange rate shocks. The results indicate that these shocks, especially the policy shocks, widen the uncovered interest parity deviations to a great extent. Our research is compatible with the empirical evidence that funding illiquidity led to a significant uncovered interest parity violation during the 2008–2009 financial crisis.

Liquidity Risk, Syndication Behaviour and the Risk Culture of Australian Venture Capital Industry

Venture capital (VC) is usually invested in high risk technology companies at their early stages of development. In response to the industry risk environment, the VC fund managers have developed a set of risk management practices appropriate for the industry which include Investment syndication. Furthermore, the VC funds are supplied by individual and institutional investors with different risk profiles and investment focus, usually in finite amounts and for a limited period of time. The funding agreement between the VC firms and the fund investors combined with the limited amount and time can lead to additional funding liquidity risks as the VC funds are invested in the portfolio companies. In this paper, we develop a simple two period model from a VC firms’ perspective with funding liquidity constraints to demonstrate how funding liquidity risk can influence syndication decisions. We subsequently analyse the implication of the model, derive a set of predictions and validate them with VC investment data from Australia. The analysis shows that syndication has both instrumental function in risk management and behavioural implications on risk culture essential for addressing the emerging frontiers of sustainability risks.

FX market liquidity, funding constraints and capital flows

We investigate the determinants of the time variation of the common component of FX market liquidity across developed and emerging market currencies. We study the impact of funding liquidity constraints, which proxy for supply considerations, and capital flows, which proxy for demand considerations of liquidity on transaction costs. Our results show that (i) funding liquidity constraints measured by the availability of outstanding repos reduce FX market liquidity, and their impact is stronger when they are associated with an increase in the costs of funding and a shortening of their maturity; (ii) increasing capital flows at the global level increase liquidity; (iii) both of these effects were stronger during the recent financial crisis, when liquidity dry-ups were severe; and (iv) the analysis of individual currencies with diverse riskiness confirms that a shock to speculator capital would lead to a reduction in market liquidity through a spiral effect that is stronger for more volatile currencies. Furthermore, we find a similar effect related to capital flows.

Oil Risk Exposure and Expected Stock Returns

After the financialization of commodity futures markets in 2004-05 oil volatility has become a strong predictor of returns and volatility of the overall stock market. Furthermore, stocks' exposure to oil volatility risk now drives the cross-section of expected returns. The difference in average return between the quintile of stocks with low exposure and high exposure to oil volatility is significant at 0.66% per month, and oil volatility risk carries a significant risk premium of -0.60% per month. In the post-financialization period, oil volatility risk is strongly related with various measures of funding liquidity constraints suggesting an economic channel for the effect.

Circuit Breakers and Market Runs

Merely out of fear for future liquidity shocks, traders may run on financial markets. We show this coordination failure could be overcome by applying circuit breakers (which curb excessive trading). However, the common-practice circuit breakers fall short of their potential and could even damage welfare. Our analysis suggests a novel forward-looking circuit breaker which (i) becomes most restrictive precisely when the expected social loss related to inefficient upfront trading is largest, and (ii) is only implemented when it yields a welfare contribution. Bridging to practice, the calibration of this welfare-optimal circuit breaker among others reflects (the fear of future) funding liquidity constraints.

FX Market Illiquidity and Funding Liquidity Constraints

We investigate the determinants of the time variation of the common component of FX market liquidity across developed and emerging market currencies. We study the impact of funding liquidity constraints, which proxy for supply considerations, and capital flows, which proxy for demand considerations of liquidity on transaction costs. Our results show that (i) funding liquidity constraints measured by the availability of outstanding repos reduce FX market liquidity, and their impact is stronger when they are associated with an increase in the costs of funding and a shortening of their maturity; (ii) increasing capital flows at the global level increase liquidity; (iii) both of these effects were stronger during the recent financial crisis, when liquidity dry-ups were severe; and (iv) the analysis of individual currencies with diverse riskiness confirms that a shock to speculator capital would lead to a reduction in market liquidity through a spiral effect that is stronger for more volatile currencies. Furthermore, we find a similar effect related to capital flows.

Limits to Arbitrage During the Crisis: Funding Liquidity Constraints and Covered Interest Parity

Limits to Arbitrage During the Crisis: Funding Liquidity Constraints and Covered Interest Parity

Limits to Arbitrage During the Crisis: Funding Liquidity Constraints and Covered Interest Parity

Arbitrage ensures that covered interest parity holds. The condition is central to price foreign exchange forwards and interbank lending rates, and reflects the efficient functioning of markets. Normally, deviations from arbitrage, if any, last seconds and reach a few basis points. After the Lehman bankruptcy, instead, arbitrage profits were large, persisted for months and involved borrowing in dollars. The first goal of this paper is to measure precisely such deviations from arbitrage. By using high frequency prices from novel datasets , we are able to exactly replicate two major arbitrage strategies: “secured” and “unsecured” arbitrage. Specifically, arbitrage can be undertaken by borrowing and lending funds on secured terms, as would a hedge fund, or on unsecured terms, as would a bank's proprietary trading desk (prop desk). The distinction draws on that made in Brunnermeier and Pedersen (2009). Both arbitrage strategies yield very similar and consistent results. The second goal of the paper is to investigate why arbitrage broke down. Empirical analysis suggests that insufficient funding liquidity in dollars kept traders from arbitraging away excess profits. Risk factors, instead, are mostly insignificant. Liquidity factors involve intermediaries cutting back loans to arbitrageurs in order to shrink their balance sheet, and hoarding liquidity to cover their own funding strains. In addition, it seems that arbitrageurs themselves had insufficient pledge-able capital to fund their arbitrage trades. This paper contributes to the literature on slow moving capital. It shows how capital constraints turn into enduring arbitrage opportunities. For policymakers, it shows that certain unconventional monetary policy measures (in particular central bank swap lines) were effective at providing the necessary funding liquidity in dollars and re-establishing arbitrage across money markets.