Funding Liquidity Shocks Research Articles

Leveraged speculators and asset prices

Abstract I test the hypothesis that the use of leverage by market speculators can increase the likelihood and magnitude of crashes in asset prices. Using a direct leverage measure derived from US public filings, I find that (1) stocks held by highly leveraged hedge funds subsequently have more negatively skewed returns than stocks held by less leveraged funds and (2) upon extremely negative earnings surprises or funding liquidity shocks, stocks owned by high-leverage funds exhibit abnormal price declines and subsequent reversal. Consistent with the fire sale and contagion hypothesis, high-leverage funds tend to reduce the position following negative news about a stock, and such selling can extend to other stocks in the portfolio, increasing the crash proneness of the stocks they hold.

Funding liquidity shocks and market liquidity providers

We examine the relationship between funding liquidity and stock market liquidity. Positive (negative) funding liquidity shocks enhance market liquidity for medium-sized (large and small) firms before Korea adopts the Basel III accord, whereas changes in funding liquidity, in general, precedes changes in market liquidity afterward. The regime-dependent relationship is attributed to the change in domestic individuals’ reaction to funding liquidity shocks. Domestic investors act as liquidity providers for the overall market as funding liquidity improves, while foreigners only trade shares of small firms in response to funding liquidity shocks.

Liquidity Shocks, Price Volatilities, and Risk-managed Strategy: Evidence from Bitcoin and Beyond

This study examines the prediction power of market liquidity (the ease with which asset are traded) and funding liquidity (the ease with which traders can obtain funding) on the price volatilities of Bitcoin. We find that both market and funding liquidity shocks forecast future volatility. More importantly, liquidity shocks have a stronger and persistent effect on the long-term trend component of volatility. Exploiting the predictability of liquidity shocks, we propose a risk-managed strategy to manage extremely high volatility and avoid occasional large crashes in cryptocurrency markets. This novel strategy virtually eliminates crashes and improves the Sharpe ratio substantially against the benchmark buy-and-hold strategy. The outperformance is much stronger during the turbulent periods of cryptocurrencies. Hence, this paper provides important insights into cryptocurrency investment and portfolio management combining traditional assets and cryptocurrencies.

Sentiment‐dependent impact of funding liquidity shocks on futures market liquidity

AbstractWe examine the effect of funding liquidity changes on futures market liquidity, depending on economic sentiment. Futures market liquidity improves following negative funding liquidity shocks, and economic sentiment is an important determinant explaining this relationship. While individuals' trading is most significantly affected by sentiment, its response to funding liquidity shocks remains independent of sentiment effects. Domestic institutions' reactions depend on the sentiment regime; they trade futures contracts more actively as funding liquidity becomes more abundant (scarcer) when sentiment is more pessimistic (optimistic). Foreigners, following negative funding liquidity shocks, generally increase their futures trading, whereas their trading decreases under the extremely pessimistic sentiment. Domestic banks and pension funds provide liquidity to the futures market even when sentiment is pessimistic.

Stock price synchronicity and liquidity: Retail investors’ risk preference under funding liquidity shocks

Stock price synchronicity and liquidity: Retail investors’ risk preference under funding liquidity shocks

Funding liquidity, credit risk and unconventional monetary policy in the Euro area: a GVAR approach

This paper investigates the transmission of funding liquidity shocks, credit risk shocks and unconventional monetary policy within the Euro area. To this aim, a financial GVAR model is estimated for Germany, France, Italy and Spain on monthly data over the period 2006-2017. The interactions between repo markets, sovereign bonds and banks' CDS spreads are analyzed, explicitly accounting for the country-specific effects of the ECB's asset purchase programmes. Impulse response analysis signals core-periphery heterogeneity and persistent flight to quality. A simulated reduction in any ECB programme ultimately results in rising yields and bank CDS spreads in Italy and Spain, as well as in falling repo trade volumes and rising repo rates in all four countries.

Transmission of funding liquidity shocks in the options market: evidence from India

ABSTRACT The extant literature examines the interactions between funding liquidity and market volatility on the equity market. This paper extends the literature and investigates the interactions between funding liquidity and market volatility in the options market. The paper employs the Bayesian structural vector autoregression framework to examine the effects of funding liquidity shock to volatility demand, uncertainty, and risk aversion. We find that positive feedback exists between contraction in funding liquidity and volatility demand, uncertainty, and risk-aversion. Our results are robust to alternate specifications of uncertainty and risk-aversion measures, and alternative ordering of variables.

Funding liquidity shocks in a quasi-experiment: Evidence from the CDS Big Bang

We use the advent of new credit default swap (CDS) trading conventions in April 2009—the CDS Big Bang—to study how a shock to funding liquidity impacts market liquidity. After the Big Bang, traders are required to pay upfront fees to execute CDS transactions, with the size of the fees depending on the level of CDS spreads. While CDS bid-ask spreads decline in aggregate after the Big Bang, they do so less for contracts that require larger fees. Furthermore, the funding effect is stronger for smaller and riskier firms and for noncentrally cleared contracts. The effect also becomes stronger after Deutsche Bank's exit.

Turning alphas into betas: Arbitrage and endogenous risk

Using data on asset pricing anomalies, I test the idea that the act of arbitrage turns “alphas” into “betas”: Assets with high initial abnormal returns attract more arbitrage and covary endogenously more with systematic factors that arbitrage capital is exposed to. This channel explains the exposures of 40 anomaly portfolios to aggregate funding liquidity shocks and arbitrageur wealth portfolio shocks. My results highlight that financial intermediaries that act as asset market arbitrageurs not only price assets given risks, but also actively shape these risks through their trades.

Resilience of Canadian banks to funding liquidity shocks

Abstract The agent-based model of Halaj (2018) is calibrated to data from granular liquidity reporting by the largest banks in Canada. The model describes propagation and amplification of funding shocks between banks interacting on the interbank market. Some stylized stress-test scenarios of funding outflows are considered to show how the model can be used to assess two vulnerabilities of the banking system: funding liquidity (which is cyclical) and interconnectedness (which is structural).

Mispricing and Uncertainty in International Markets

We develop Residual MisPricing (RMP), an index capturing mispricing relative to a linear benchmark asset pricing model, from the structure imposed by no-arbitrage. RMP is fully conditional and depends only on the returns of basic assets. Return data for several economies reveal that RMP is countercyclical and related to financial uncertainty. RMP further shows a strong positive relation to conditional international equity and currency risk premia, as well as a close link to market-wide funding liquidity shocks. The relations we document hold in particular out-of-sample. Our evidence points to new record highs for RMP during the COVID-19 era, similar to its behavior in the 2008 financial crisis.

Tail risk in hedge funds: A unique view from portfolio holdings

We develop a new systematic tail risk measure for equity-oriented hedge funds to examine the impact of tail risk on fund performance and to identify the sources of tail risk. We find that tail risk affects the cross-sectional variation in fund returns and that investments in both tail-sensitive stocks and options drive tail risk. Moreover, leverage and exposure to funding liquidity shocks are important determinants of tail risk. We find evidence of some funds being able to time tail risk exposure prior to the 2008–2009 financial crisis.

Lenders on the storm of wholesale funding shocks: saved by the central bank?

ABSTRACTWe provide empirical evidence on banks’ responses to shocks in the wholesale funding market, using data of 181 euro area banks over the period from August 2007 to June 2013. Responses to funding liquidity shocks for both banks’ lending volumes and loan rates, to households and corporates, are analysed in a panel VAR framework. We thereby distinguish banks by country, extent of Eurosystem borrowing, bank size and capitalization. The results show that shocks in the securities and interbank markets have significant effects on loan rates and credit supply, particularly of banks in stressed countries of the periphery. The results also suggest that central bank liquidity has mitigated this effect on lending volumes. Lending to nonfinancial corporations is more sensitive to wholesale funding shocks than lending to households. Lending volumes of large banks that are typically more dependent on wholesale funding and banks with large exposure to sovereign bonds show stronger responses to wholesale funding shocks.

Reversals in Global Market Integration and Funding Liquidity

This paper looks at the reversals in global financial integration through the funding liquidity lens. First, we construct a segmentation indicator based on differences in funding liquidity across countries as measured by the performance of betting-against-beta strategies. Second, we find that funding liquidity shocks help explain recent reversals in integration in the absence of explicit foreign investment barriers. These findings are consistent with tighter limits to arbitrage and increased home bias during funding distress periods. Our empirical analysis is guided by a margin-CAPM model generalized to an international setting.

Rollover risk and credit risk under time-varying margin

For a firm financed by a mixture of collateralized (short-term) debt and uncollateralized (long-term) debt, we show that fluctuations in margin requirements, reflecting funding liquidity shocks, lead to increasing the firm’s default risk and credit spreads. The severity with which a firm is hit by increasing margin requirements highly depends on both its financing structure and debt maturity structure. Our results imply that an additional premium should be added when evaluating debt in order to account for rollover risks, especially for short-matured bonds. In terms of policy implications, our results strongly indicate that regulators should intervene fast to curtail margins in crisis periods and maintain a reasonably low margin level in order to effectively prevent creditors’ run on debt.

Prime Broker-Level Comovement in Hedge Fund Returns: Information or Contagion?

We document strong comovement in the returns of hedge funds sharing the same prime broker. This comovement is driven neither by funds in the same family nor in the same style, and it is distinct from market-wide and local comovement. The common information hypothesis attributes this phenomenon to the prime broker providing valuable information to its hedge fund clients. The prime broker-level contagion hypothesis attributes the comovement to the prime broker spreading funding liquidity shocks across its hedge fund clients. We find strong evidence supporting the common information hypothesis, but little evidence in favor of the prime broker-level contagion hypothesis.

MBS Liquidity: Drivers and Risk Premiums

This paper shows that funding liquidity risk is priced in the cross-section of excess returns on agency mortgage-backed securities (MBS). We derive a measure of funding liquidity risk from dollar-roll implied financing rates (IFRs), which reflect security-level costs of financing positions in the MBS market. We show that factors representing higher net MBS supply are generally associated with higher IFRs, or higher funding costs. In addition, we find that exposure to systematic funding liquidity shocks embedded in the IFRs is compensated in the cross-section of expected excess returns| agency MBS that are better hedges to funding liquidity shocks on average deliver lower excess returns-and that these premiums are separate from the premiums associated with prepayment risks.

Funding Liquidity Risk and the Cross-section of MBS Returns

This paper shows that funding liquidity risk is priced in the cross-section of excess returns on agency mortgage-backed securities (MBS). We derive a measure of funding liquidity risk from dollar-roll implied financing rates (IFRs), which reflect security-level costs of financing positions in the MBS market. We show that factors representing higher net MBS supply are generally associated with higher IFRs, or higher funding costs. In addition, we find that exposure to systematic funding liquidity shocks embedded in the IFRs is compensated in the cross-section of expected excess returns| agency MBS that are better hedges to funding liquidity shocks on average deliver lower excess returns-and that these premiums are separate from the premiums associated with prepayment risks.

Lenders on the Storm of Wholesale Funding Shocks: Saved by the Central Bank?

We provide empirical evidence on banks’ responses to shocks in wholesale funding, using data of 181 euro area banks over the period August 2007 to June 2013. Banks’ adjustments of loan volumes and lending rates in response to funding liquidity shocks are analysed in a panel VAR framework. The results show that shocks in the securities and interbank markets have significant effects on loan rates and credit supply, particularly of banks in stressed countries. The results also suggest that central bank liquidity has mitigated this effect most clearly on lending volumes. Lending to non-financial corporations is more sensitive to wholesale funding shocks than lending to households. Moreover, bank characteristics matter for monetary transmission: loan growth of large banks that are typically more dependent on wholesale funding and of banks with large exposure to government bonds shows relatively stronger responses to wholesale funding shocks.

Funding Liquidity Shocks in a Natural Experiment: Evidence from the CDS Big Bang

The CDS Big Bang (the protocol changes for the CDS market in April 2009) increased the upfront funding requirements for trading CDS contracts, especially for those with credit spreads further away from 100 and 500 basis points. Exploiting this natural experiment, we document direct evidence that a higher funding requirement reduces market liquidity, increases the absolute value of the CDS-bond basis, and CDS spread volatility. Our evidence highlights an unintended consequence of the ongoing standardization of OTC markets — while its intention is to reduce systemic risk, standardization may jeopardize market liquidity precisely during periods of financial distress.