Liquidity Costs Research Articles

Dynamic Liquidity Management by Corporate Bond Mutual Funds

This paper explores dynamic liquidity management by 578 open-end corporate bond funds during the period from 2002 to 2014. We find that during tranquil markets, managers of corporate bond funds tend to reduce their holdings of liquid assets such as cash and government bonds to meet investor redemptions, engaging in a “horizontal cut” of their asset allocations along the liquidity spectrum. During periods with heightened macroeconomic uncertainty, however, managers tend to liquidate relatively proportionally across asset classes, pursuing a “vertical cut” and maintaining portfolio liquidity. Consistent with the existence of a target ratio of liquid assets, we find that managers tend to sell illiquid assets to restore their holdings of liquid assets subsequent to investor redemptions, especially amid elevated macroeconomic uncertainty. Turning to individual securities, we find that when liquidating corporate bonds to meet redemptions, managers tend to follow a “liquidity pecking order,” selling relatively liquid corporate bonds first, which could mitigate immediate asset liquidation costs. The micro-level liquidity management practices of corporate bond funds have implications for financial stability of broad markets.

Banking Crises, R&D Investments and Slow Recoveries

This paper studies the effect of banking crises on the composition of investment and economic growth. It builds a partial equilibrium growth model with a banking sector and two types of investment projects: a safe, low return technology and an innovative, high productivity one. Investments in innovation are risky since they are subject to a liquidity cost which entrepreneurs cover by borrowing from the banking sector. When bank creditors are sufficiently pessimistic about the aggregate liquidity needs of the real sector, they will run on the bank and cause a credit freeze. This leads banks to tighten credit supply after the crisis, which decreases disproportionately investment in innovation and slows down economic growth. Industry-level data on R&D investment supports this hypothesis for 13 recent banking crises episodes. Industries that depend more on external finance, in more bank-based economies, invest disproportionately less in R&D following episodes of banking distress. These industries also have a relatively lower share of R&D in total investment, suggesting a shift in the composition of investment after the crisis. Such differential effects across sectors imply that the drop in R&D spending is, at least partially, the result of a credit supply shock.

Portfolio Liquidity Risk: A Practitioner Perspective

Since the recent financial crisis, global institutions and governments strove for reducing both individual bank risk and systematic risks. New regulatory requirements have been proposed and then introduced in recent reforms and financial directives for the global markets. Above all, a new awareness of the importance of market liquidity as a crucial ingredient for the market functioning emerged and consequently a lot of efforts have been put in place in order to provide an unbiased measurement of its current level and to be able to obtain a reasonable forecast for the future. Even if the concept of liquidity may be well-spread among professionals, a common, largely agreed, quantitative approach within portfolio theory and risk management is still lacking, and practitioners are more inclined to consider their contingent situations with ad-hoc recipes and guidelines, rather than to follow a standardize framework based on firm ground.In this article we focus on the point of view of a fund asset manager which wants to know the actual value of her portfolio in an illiquid market and quantify her liquidity risk associated. Within Acerbi-Scandolo framework, we shall distinguish between assessing the value or pricing a portfolio and the quest of the optimal buy/sell strategy to obtain a performance benchmark in a given time horizon, which is more the domain of investment management rather than pricing.This analysis gives us the possibility to focus directly on the today assessment of the cost to bear in the case that one needs or simply wants to liquidate her position in an illiquid market, where not every position to sell can find an other at the best price. This reasoning leads us to the second part of the present paper, where we give an economically sensible estimation of the today supply-and-demand curve and quantify the bounds for the liquidity cost in very simple terms. In particular, our lower bound L is rather simple to implement and it can be used by any financial practitioner as a robust and conservative measure of the liquidity cost which takes into account both exogenous and endogenous aspects of asset liquidity risk.

Development and application of electric arc furnace combined blowing technology

A number of electric arc furnace (EAF) plants in China use high proportions of hot metal in the charge because of availability of excess liquid iron at the steelworks and/or because of the high price of scrap relative to hot metal. Liquid steel costs are still higher than the basic oxygen furnace as the EAF is not as efficient when refining liquid iron. EAF combined blowing technology has been modelled and installed in industrial plants with the aim of increasing stirring and hence improving refining. The industrial application of the combined blowing technology in a number of steel plants indicates that the combined blowing technology of EAF can effectively improve the pool stirring strength and reaction dynamics condition of the molten pool, and optimise production.

An Information-Based Theory of Time-Varying Liquidty

We propose an information-based theory to explain time variation in liquidity and link it to a variety of patterns in asset markets. In normal times, the market is fully liquid and gains from trade are realized immediately. However, the equilibrium also involves periods during which liquidity endogenously dries up, shares remain in the hands of financially constrained traders despite gains from trade, which leads to endogenous liquidation costs. Traders correctly anticipate such costs, which reduces their willingness to pay. This foresight leads to a novel feedback effect between prices and the degree of market liquidity, which are jointly determined in equilibrium. The model also predicts that contagious sell-offs can occur after sufficiently bad news; a trade at a low price reveals information, which facilitates the trade of additional shares. Implications for efficiency and trade volume are discussed.

An Information‐Based Theory of Time‐Varying Liquidity

ABSTRACTWe propose an information‐based theory to explain time variation in liquidity and link it to a variety of patterns in asset markets. In “normal times,” the market is fully liquid and gains from trade are realized immediately. However, the equilibrium also involves periods during which liquidity “dries up,” which leads to endogenous liquidation costs. Traders correctly anticipate such costs, which reduces their willingness to pay. This foresight leads to a novel feedback effect between prices and market liquidity, which are jointly determined in equilibrium. The model also predicts that contagious sell‐offs can occur after sufficiently bad news.

Risk Management for Whales

We propose framework for modeling portfolio risk which integrates market risk with liquidation costs which may arise in stress scenarios. Our model provides a systematic method for computing liquidation-adjusted risk measures for a portfolio. Calculation of Liquidation-adjusted VaR (LVaR) for sample portfolios reveals a substantial impact of liquidation costs on portfolio risk for portfolios with large concentrated positions.

Liquidation discount—a novel application of ARFIMA–GARCH

Urgent liquidation of a large stock portfolio entails a liquidity cost—i.e., a “liquidation discount”. This is the market impact discount in value yielded by the immediate sale of the portfolio relative to its in-hand market value calculated from prevailing market prices. For any portfolio, the day-to-day liquidation discount “at risk” (i.e., the liquidation discount that would be suffered if liquidation were undertaken) is variable. This liquidation discount risk is additional to price risk and will be of concern to portfolio managers that may, at short notice, wish to convert substantial stockholdings to cash. We obtain daily time series of instantaneous log liquidation discount for variously sized portfolios of Australian stocks and determine that these time series are best modeled with an Autoregressive Fractionally Integrated Moving Average-Generalized Autoregressive Conditional Heteroskedasticity (ARFIMA–GARCH) process. We then formulate a liquidation discount-at-risk measure with which portfolio managers can budget for the future cost of portfolio liquidity for a chosen liquidation horizon and confidence level.

Scrubber liquid recovery in biomass gasification plants: centrifugation as a method for tar separation

Many gasification plants use scrubber systems for the removal of tars from producer gas. The cost of the scrubber liquid represents a considerable part of the operating cost, which could be decreased by regenerating the spent scrubber liquid by separating it from ash residues and heavy tars. In this study, different types of spent scrubber liquids were regenerated using a centrifuge. The effect of centrifugation time (1.5–10 min) and sample temperature (50–90 °C) on the separation efficiency was studied. Based on the results, the separation of tars from the scrubber liquids can be ranked as follows: diesel > RME > linoleic acid > linseed oil > rapeseed oil > motor oil. This ranking correlates to the viscosity of the different scrubber liquids, with the separation efficiency increasing with decreasing scrubber liquid viscosity. The best separation efficiency was achieved for scrubber liquids with low viscosity at 90 °C and 10 min of centrifugation time. The results obtained indicate that centrifugation can be used for the regeneration of spent scrubber liquid.

Liquidity Costs: A New Numerical Methodology and an Empirical Study

ABSTRACTWe consider rate swaps which pay a fixed rate against a floating rate in the presence of bid-ask spread costs. Even for simple models of bid-ask spread costs, there is no explicit strategy optimizing an expected function of the hedging error. We here propose an efficient algorithm based on the stochastic gradient method to compute an approximate optimal strategy without solving a stochastic control problem. We validate our algorithm by numerical experiments. We also develop several variants of the algorithm and discuss their performances in terms of the numerical parameters and the liquidity cost.

Option pricing in a CEV model with liquidity costs

Option pricing in a CEV model with liquidity costs

Arbitrage with Production, Collateral Constraint and Heterogeneous Belief

We construct a dynamic model economy in which households from segmented markets have varying financial asset demands. Intermediaries make arbitrage profit by exploiting the price difference in segmented financial markets. Meanwhile, they are required to separately post their production investment as collateral to support liquidity supply. We show that without uncertainty the intermediaries exhibit self-recovery capacity after negative shocks. We also demonstrate that with uncertainty and agents' inaccurate estimation of future market demand, looser collateral constraints can disturb such self-recovery process and further incur systemic risk through over investment in financial markets and under investment in production. On the contrary, tighter collateral constraints can stabilise the economy and boost the production sector at the cost of market liquidity. The dynamic interaction between the endogenous collateral constraint and liquidity supply turns out to be a powerful transmission mechanism by which the effects of disturbance persist, amplify and spill over to other sectors.

Fragmentation vs. Consolidation in Spanish Stock Exchange. A Note

After the implementation of MiFID (I and II), competition is a reality in all the European Cash Markets. A natural consequence of competition is that order flow is fragmented in different type of venues. This paper focuses on the consequences of fragmentation on the local market liquidity of the Spanish Stock Exchange (hereafter SSE). Our main result shows that, for our sample, fragmentation is relevant determining the cost of liquidity. Following the analysis of Degryse, de Jong and van Kervel (2014), the linear component of fragmentation has a positive and significant effect on liquidity (reduces spreads and increases Kyle’s Lambda) and the quadratic term has a negative and significant effect on liquidity (increases spreads and reduces Kyle’s Lambda). So, fragmentation is good for liquidity but beyond a given level of fragmentation, increasing it is worse for the liquidity of the regulated market.

Dynamic Portfolio Optimisation with Intermediate Costs: A Least-Squares Monte Carlo Simulation Approach

We propose a dynamic portfolio optimisation strategy that takes liquidity cost into account. Our liquidity cost model is built upon the so-called Marginal Supply-Demand Curve which describes the asset price as a function of the trading volume. We extend the least-squares Monte Carlo algorithm to a stochastic control problem with switching costs and endogenous state variables. This approach is simulation-based, with great flexibility in the choice of investor objective, asset dynamics, portfolio constraints, intermediate consumption and incorporation of different sources of costs, making it easy to implement in practice. We study a portfolio investing in four major sectors in the U.S. market. We benchmark our dynamic strategy against several alternative portfolio strategies in terms of the out-of-sample distribution of terminal wealth and the real market performance. Overall, our dynamic strategy outperforms other standard asset allocation strategies.

Bund for Glory, or It's a Long Way to Tip a Market

Journal of Applied Corporate FinanceVolume 27, Issue 4 p. 81-87 Original Articles Bund for Glory, or It's a Long Way to Tip a Market Craig Pirrong, Craig Pirrong CRAIG PIRRONG is Professor of Finance at the University of Houston's Bauer College of Business.Search for more papers by this author Craig Pirrong, Craig Pirrong CRAIG PIRRONG is Professor of Finance at the University of Houston's Bauer College of Business.Search for more papers by this author First published: 28 January 2016 https://doi.org/10.1111/jacf.12149AboutPDF ToolsRequest permissionExport citationAdd to favoritesTrack citation ShareShare Give accessShare full text accessShare full-text accessPlease review our Terms and Conditions of Use and check box below to share full-text version of article.I have read and accept the Wiley Online Library Terms and Conditions of UseShareable LinkUse the link below to share a full-text version of this article with your friends and colleagues. Learn more.Copy URL Share a linkShare onFacebookTwitterLinkedInRedditWechat Volume27, Issue4Fall 2015Pages 81-87 RelatedInformation

Variety expansion, preference shocks, and financial intermediaries

We investigate the effect of lifetime uncertainty on economic growth by incorporating preference shocks into a variety-expansion model and comparing financial autarky and financial intermediaries. In this economy, long-term investment facilitates the promotion of R&D investment and the creation of new differentiated goods. Our results suggest that when risk aversion is high, an increase in number of differentiated goods slows down R&D investment through a decrease in the price index. Further, if the risk of early withdrawal and the liquidation cost of long-term investment are high, financial intermediaries have significant effects on the growth of variety.

Uniqueness of equilibrium in a payment system with liquidation costs

We study a financial network where forced liquidations of an illiquid asset have a negative impact on its price, thus reinforcing network contagion. We give conditions for uniqueness of the clearing asset price and liability payments. Our main result holds under mild and natural assumptions on the price impact function: monotonicity of the price impact function and strict monotonicity of the proceeds of liquidation in the liquidated quantity.

Liquidity cost vs. real investment efficiency

We study a model featuring endogenous information acquisition. Investment opportunities regularly depend on sources of uncertainty captured by prices. Learning from prices is crucial when investment efficiency matters. Trading profits of speculators in the secondary market lead to liquidity costs. Insider trading by the decision maker partially crowds out speculators but reduces investment efficiency. This can create a tradeoff between liquidity cost and investment efficiency that determines the information acquisition of decision makers. We find that the consideration of price discounts in the primary market incentivizes the decision maker to rely less on informational feedback from prices.

Foreign Investor Heterogeneity and Stock Liquidity around the World*

This article examines whether foreign investor heterogeneity plays a role in stock liquidity in a sample of 27,828 firms from thirty-nine countries worldwide. Foreign direct ownership is negatively associated with stock liquidity, while foreign portfolio ownership is positively associated with stock liquidity. Consistent with theoretical predictions, foreign ownership explains stock liquidity through both trading activity and information channels. The value-enhancing benefits of foreign direct investors’ monitoring efforts outweigh their liquidity costs and high adverse selection premium. However, the positive impact of foreign portfolio ownership on firm performance becomes negative and is not robustly significant after controlling for liquidity.

Distilling Liquidity Costs from Limit Order Books

This paper proposes a method to compute ex-ante trading costs from limit order books. Using nearly 500 of the largest traded companies in the NYSE ArcaBook, we show that these costs have nontrivial intraday dynamics, are negatively related to volume and positively related to volatility, and react to macroeconomic intraday announcements. When ex-ante trading costs are incorporated into price impact specifications, the results show that this measure provides relevant information about price changes of the overall market. Our evidence suggest that ex-ante trading costs constitute a new source of information for the study of intraday liquidity.