Global liquidity risk in the foreign exchange market

Using a broad data set of 20 US dollar exchange rates and order flow of institutional investors over 14 years, we construct a measure of global liquidity risk in the foreign exchange (FX) market. Our FX liquidity measure may be seen as the analog of the well-known Pastor–Stambaugh liquidity measure for the US stock market. We show that this measure has reasonable properties, and that there is a strong common component in liquidity across currencies. Finally, we provide evidence that liquidity risk is priced in the cross-section of currency returns, and estimate the liquidity risk premium in the FX market around 4.7 percent per annum.     

The world price of liquidity risk

This paper empirically tests the liquidity-adjusted capital asset pricing model of Acharya and Pedersen (2005) on a global level. Consistent with the model, I find evidence that liquidity risks are priced independently of market risk in international financial markets. That is, a security’s required rate of return depends on the covariance of its own liquidity with aggregate local market liquidity, as well as the covariance of its own liquidity with local and global market returns. I also show that the US market is an important driving force of global liquidity risk. Furthermore, I find that the pricing of liquidity risk varies across countries according to geographic, economic, and political environments. The findings show that the systematic dimension of liquidity provides implications for international portfolio diversification.     

Can hedging tell the full story? Reconciling differences in United States aggregate- and industry-level exchange rate risk premium

While the importance of currency movements to industry competitiveness is theoretically well established, there is little evidence that currency risk impacts US industries. Applying a conditional asset pricing model to 36 US industries, we find that all industries have a significant currency premium that adds about 2.47 percentage points to the cost of equity and accounts for approximately 11.7% of total risk premium in absolute value. Cross-industry variation in the currency premium is explained by foreign income, industry competitiveness, leverage, liquidity, and other industry characteristics, while its time variation is explained by US aggregate foreign trade, monetary policy, growth opportunities, and other macro variables. The results indicate that methodological weakness, not hedging, explains the insignificant industry currency risk premium found in previous work, thus resolving the puzzle that currency risk premium is important at the aggregate stock market level, but not at the industry level.     

A liquidity-augmented capital asset pricing model

Using a new measure of liquidity, this paper documents a significant liquidity premium robust to the CAPM and the Fama–French three-factor model and shows that liquidity is an important source of priced risk. A two-factor (market and liquidity) model well explains the cross-section of stock returns, describing the liquidity premium, subsuming documented anomalies associated with size, long-term contrarian investment, and fundamental (cashflow, earnings, and dividend) to price ratios. In particular, the two-factor model accounts for the book-to-market effect, which the Fama–French three-factor model fails to explain.     

Pricing of time-varying liquidity risk in Finnish stock market: new evidence

Using two recently developed illiquidity measures, we estimate a conditional version of liquidity-adjusted capital asset pricing model (LCAPM), which allows for a time-varying decomposition of the total illiquidity premium into a level component and three risk components. The total estimated annualized illiquidity premium for the Finnish equities during 1997–2015 is 1.13–1.90% depending on the illiquidity measure. Of the three systematic liquidity risk components, risk arising from hedging of wealth shocks is the most important followed by commonality in liquidity risk, whereas flight to liquidity risk is not significantly priced in the Finnish stock market. Our results show that the liquidity risk is time varying, therefore the models estimating the risk-return relationship should address the issue of conditionality.     

Divergence of US and Local Returns in the After‐market for Equity Issuing ADRs

We study one‐year post‐listing prices and returns to equity issuing ADRs that listed in the US between January 1991 and October 2000. ADRs from countries that impose restrictions on capital flows are priced at a premium to their home market ordinaries. While the mean premium for the full sample is statistically indistinguishable from zero, after an adjustment for asynchronous trading, the magnitude of the premium to ADRs from restricted markets is 11.33% at the 300‐day post listing interval, which is statistically significant. In the short run (30 days) following listing, the magnitude of the premium is larger for ADRs with larger excess demand from US investors. At the longer 300‐day horizon, Nasdaq listed ADRs earn a larger premium than their NYSE/AMEX listed counterparts. Time‐series regressions and two‐stage cross‐sectional regressions establish that the premium to foreign equity issuers is greater if the US listing attracts liquidity and if US returns have a lower correlation with the local country index.     

Comoment risk and stock returns

We estimate investable comoment equity risk premiums for the US markets. The stock's contribution to the asymmetry and the fat tails of the market portfolio's payoff are priced into a coskewness premium and a cokurtosis premium. We construct zero-investment strategies that are long and short in coskewness and cokurtosis equity risks; we infer from the spread the returns attached to a unit exposure to US equity coskewness and cokurtosis. The coskewness and cokurtosis premiums present positive monthly average returns of 0.27% and 0.14% from January 1959 to December 2011. Comoment risks appear to be significantly priced within the US stock market and display significant explanatory power regarding the US size and book-to-market effects. The premiums do not subsume, but rather complement the empirical capital asset pricing model. Our analysis relies on data collected from CRSP (Chicago Research Center for Security Prices) over December 1955 to December 2011. To our knowledge, the paper is the first to propose investable higher-moment risk factors over such an extensive time period.     

Time‐Varying Risk–Return Trade‐off in the Stock Market

We uncover a strong comovement of the stock market risk–return trade‐off with the consumption–wealth ratio (CAY). The finding reflects time‐varying investment opportunities rather than countercyclical aggregate relative risk aversion. Specifically, the partial risk–return trade‐off is positive and constant when we control for CAY as a proxy for investment opportunities. Moreover, conditional market variance scaled by CAY is negatively priced in the cross‐section of stock returns. Our results are consistent with a limited stock market participation model, in which shareholders require an illiquidity premium that increases with CAY, in addition to the risk premium that is proportional to conditional market variance.     

Factor pricing in commodity futures and the role of liquidity

This paper empirically investigates the pricing factors and their associated risk premiums of commodity futures. Existing pricing factors in equity and bond markets, including market premium and term structure, are tested in commodity futures markets. Hedging pressure in commodity futures markets and momentum effects is also considered. This study combines these factors to discuss their importance in explaining commodity future returns, while the literature has studied these factors separately. One of the important pricing factors in equity and bond markets is liquidity, but its role as a pricing factor in commodity futures markets has not yet been studied. To our knowledge, this research is the first to study liquidity as a pricing factor in commodity futures. The risk premiums of two momentum factors and speculators’ hedging pressure range from 2% to 3% per month and are greater than the risk premiums of roll yield (0.8%) and liquidity (0.5%). The result of a significant liquidity premium suggests that liquidity is priced in commodity futures.     

Australian and US interest rate swap markets: comparison and linkages

We investigate and compare the determinants of US and Australian interest rate swap spreads and the linkages between these markets. The slope of the risk‐free term structure is the most significant determinant and its importance is greater for longer terms to maturity. Interest rate levels and, in Australia, the default premium also have some impact. The influences of interest rate volatility, the liquidity premium and (in the USA) the default premium are small or negligible. We hypothesise, and our evidence confirms, that the US swap market significantly affects the Australian swap market but not vice‐versa.     

Does liquidity drive stock market returns? The role of investor risk aversion

In this paper, we explore the relations between liquidity, stock returns, and investor risk aversion as captured by the variance risk premium (VRP). This is motivated by theoretical and empirical evidence in the literature which suggests that investor risk aversion negatively correlates with asset liquidity, and ample empirical evidence documenting liquidity risk premium. We use monthly US data from January 1999 to December 2018 and show that innovations in the VRP Granger-cause stock returns, which in turn drive liquidity. Our findings are consistent with predictions of prior theories and highlight the predictability of the VRP. They also contribute to the on-going debate on the causal relation between stock returns and liquidity. Finally, we explore the channels through which the VRP impacts liquidity and find that the VRP influences market and momentum factors, and that movements in these factors lead to changes in liquidity.

     

What drives the cost of US dollar bond funding for banks?

This paper decomposes issue spreads on US dollar-denominated bonds issued by LIBOR panel banks into credit risk and liquidity premium components. We attribute the recent increase in issue spreads to the investor perception that banks are less creditworthy than in the past. Although the behaviour of the credit risk component is well-explained by a structural model of default, this mechanism is nullified by the introduction of government guarantees. The behaviour of the liquidity premium component is partially explained by the bid/ask spread in the secondary market and issue size. Government guarantees also reduce the liquidity component of the issue spread.     

Endogenous liquidity in credit derivatives

We study the determination of liquidity provision in the single-name credit default swap (CDS) market as measured by the number of distinct dealers providing quotes. We find that liquidity is concentrated among large obligors and those near the investment-grade/speculative-grade cutoff. Consistent with endogenous liquidity provision by informed financial institutions, more liquidity is associated with obligors for which there is a greater information flow from the CDS market to the stock market ahead of major credit events. Furthermore, the level of information heterogeneity plays an important role in how liquidity provision responds to transaction demand and how liquidity is priced into the CDS premium.     

International asset pricing models and currency risk: Evidence from Finland 1970–2004

In this paper we investigate whether global, local and currency risks are priced in the Finnish stock market using conditional international asset pricing models. We take the view of a US investor. The estimation is conducted using a modified version of the multivariate GARCH framework of [De Santis, G., Gérard, B., 1998. How big is the premium for currency risk? Journal of Financial Economics 49, 375–412]. For a sample period from 1970 to 2004, we find the world risk to be time-varying. While local risk is not priced for the USA, the local component is significant and time-varying for Finland. Currency risk is priced in the Finnish market, but is not time-varying using the De Santis and Gérard specification. This suggests that the linear specification for the currency risk may not be adequate for non-free floating currencies.     

Pricing the commonality across alternative measures of liquidity

We estimate latent factor models of liquidity, aggregated across various liquidity measures. Shocks to assets’ liquidity have a common component across measures which accounts for most of the explained variation in individual liquidity measures. We find that across-measure systematic liquidity is a priced factor while within-measure systematic liquidity does not exhibit additional pricing information. Controlling for across-measure systematic liquidity risk, there is some evidence that liquidity, as a characteristic of assets, is priced in the cross-section. Our results are robust to the inclusion of other equity characteristics and risk factors, such as market capitalization, book-to-market, and momentum.     

Why Is Long‐Horizon Equity Less Risky? A Duration‐Based Explanation of the Value Premium

We propose a dynamic risk‐based model that captures the value premium. Firms are modeled as long‐lived assets distinguished by the timing of cash flows. The stochastic discount factor is specified so that shocks to aggregate dividends are priced, but shocks to the discount rate are not. The model implies that growth firms covary more with the discount rate than do value firms, which covary more with cash flows. When calibrated to explain aggregate stock market behavior, the model accounts for the observed value premium, the high Sharpe ratios on value firms, and the poor performance of the CAPM.     

The intertemporal relationship between market return and variance: an Australian perspective

In this paper we investigate the intertemporal relationship between the market risk premium and its conditional variance in an Australian setting. Using a bivariate EGARCH‐M model combined with the dynamic conditional correlation (DCC) framework as proposed by Engle (2000), we find evidence of a positive relationship between the market risk premium and its variance and evidence of two distinct interest rate effects. Furthermore, while the bond market's own variance is not priced by investors, we find that the covariance between equity and bond markets is a significant risk factor that is priced in the market.     

Arbitrage,Liquidity, and the Valuation of Exchange Traded Funds

This paper investigates the performance of U.S. and country exchange traded funds currently traded in the United States and provides new insight into their pricing. While the U.S. funds are priced closely to their net asset values, the country funds are not and can exhibit large, positive autocorrelations in fund premium. The mispricing of country funds is related to momentum, illiquidity, and size effects. We also find an inverted U‐shaped relationship between fund premium and market liquidity, which suggests that more active trading does lead to lower mispricing but only after a certain level of liquidity is reached.     

Macro Liquidity Risk,Money Growth,and the Cross-Section of Stock Returns: The Case of Korea

According to the homogeneity of money holding purpose, we decompose the broad money M2 into an underlying and a non-underlying part and propose innovations in future non-underlying M2 growth as a proxy for macro liquidity. In both the cross-sectional regression tests and the GMM tests, we find that risk related to innovations in future non-underlying M2 growth is strongly significantly priced in Korea, after controlling for the well-known risk factors and other macroeconomic variables. Meanwhile, risk related to innovations in future aggregate or underlying M2 growth is insignificantly priced. These results indicate that non-underlying M2 growth more directly affects macro liquidity than does aggregate or underlying M2 growth.     

Estimating liquidity premia in the Spanish government securities market

This paper investigates the presence of liquidity premia in the relative pricing of assets traded on the Spanish government securities market. First, a classification of bonds into four different categories based on their degree of liquidity is proposed. Second, liquidity premia are estimated introducing liquidity parameters in the estimation of the zero-coupon yield curve. Results suggest the existence of a liquidity premium for post-benchmark bonds (both strippable and non-strippable). The size of this premium is relatively small. In the case of pre-benchmark bonds, the lack of liquidity does not seem to be priced. It is also shown that these pricing discrepancies are robust to the impact of taxes on bonds.