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.

     

How do global banks scramble for liquidity? Evidence from the asset-backed commercial paper freeze of 2007

We investigate how banks scrambled for liquidity following the asset-backed commercial paper (ABCP) market freeze of August 2007 and its implications for corporate borrowing. Commercial banks in the United States raised dollar deposits and took advances from Federal Home Loan Banks (FHLBs), while foreign banks had limited access to such alternative dollar funding. Relative to before the ABCP freeze and relative to their non-dollar lending, foreign banks with ABCP exposure charged higher interest rates to corporations for dollar-denominated syndicated loans. The results point to a funding risk manifesting as currency shortages for banks engaged in maturity transformation in foreign countries.     

The fair value of a token: How do markets price cryptocurrencies?

With the rise of cryptocurrency tokens as a new asset class, the question of the fair evaluation of a cryptocurrency token has become a question of increasing importance. We estimate the pricing kernel with which users price factors affecting their token holdings. We investigate how traditional risk factors such as market risk are evaluated, as well as how blockchain specific risk factors are priced in. In order to do so, we introduce an asset pricing model and modify its properties to make it applicable to cryptocurrency markets. We group the risk factors into market related and Bitcoin- and Ethereum blockchain specific risk factors. We find that blockchain specific risk factors are priced in. There is evidence that risk factors have moved from Bitcoin to Ethereum specific risk factors with an increasing importance of market factors, providing evidence for a decoupling of on-chain and off-chain trading activity.     

How do banks adjust their capital ratios?

We analyze the dynamics of banks’ regulatory capital ratios. Using monthly regulatory data of large German banks, we estimate the target level and the adjustment speed of the capital ratio for each bank separately. There exists a target level for a substantial percentage of banks. Unlike with panel regressions, we can estimate individual adjustment speeds and find large variation across banks. Adjustments on the liability side are most effective, although adjustment rates on the asset side are higher. Private commercial banks (neither state-owned nor cooperative) and banks with a high level of proprietary trading are more likely to adjust their capital ratio tightly. Banks with a target capital ratio compensate for low target ratios with low asset volatilities and high adjustment speeds. They seem to care mainly about the resulting probability to comply with the regulatory minimum. Assuming low variation of this probability explains most of the large cross-sectional variation of bank capital.     

How do people perceive graphical risk communication? The role of subjective numeracy

This study aims to evaluate directly how a graphical risk ladder is perceived and how this perception is related to people’s subjective numeracy. Gaze durations and frequencies were used to examine visual attention. Participants (N = 47) appeared to focus on the target risk information, whereas referential information was less attended. Subjective numeracy was negatively correlated with total watching time and the absolute number of gaze events. Results suggest that participants with low subjective numeracy have more difficulty in comprehending the graph, and that they process the graphical information less efficiently than the participants with high subjective numeracy. In addition, the position of referential risks on risk ladders could influence people’s risk perception. Based on these findings, we provide some implications for the design of risk communication graphs and for the use of graphs in informing persons with low subjective numeracy about risks.     

Do more competitive banks have less market power? The evidence from Central and Eastern Europe

Studies that have explored the competitive behaviour of banks frequently arrive at divergent conclusions because they use different measures of competition. This study first discusses these various measures of competition and their divergence from a theoretical perspective and then employs them to measure the competitiveness of Central and Eastern European banks and to investigate whether more competitive banks really have less market power. We find that these banks increase their market power when there is low banking concentration and do not necessarily become less competitive. Moreover, a more concentrated banking market does not enhance the market power of banks and does not make them less competitive, and more competitive banks do not necessarily have less market power. This latter outcome ensues because revenue and production reactions to cost evolution are either positively related – or completely unrelated – to the competitive behaviour of banks.     

How do macroeconomic news surprises affect round-the-clock price discovery of gold?

We examine round-the-clock international price discovery of gold among the major gold markets—New York, London and Shanghai during news-intensive and no-news time zones using one-minute data. Using GMM based parallel price discovery measure, we find global leadership of the US as New York gold futures lead across five time zones with 56% information share. New York/London (Nylon) timezone (51%) is the most informative trading session in sequential price discovery for all markets in 24-h. Our aggregate and disaggregate news analysis reveals that the US news surprises have a substantial and positive impact on its price discovery leadership while Eurozone news surprises have a negative impact and Chinese news have negligible impact. Using least absolute shrinkage and selection operator (LASSO) regression, we find scheduled news with a large surprise index has a significant yet asymmetric impact as negative news triggers a strong reaction. The impact of news surprise is state-dependent and display sign-reversals during extreme uncertainty, adverse macroeconomic conditions and abnormal investor behaviour.     

How do banks respond to shocks? A dynamic model of deposit-taking institutions

This paper proposes a dynamic model of the optimal choices of a bank that benefits from market power and takes into account the impact of the deposit generation process. Interbank lending/borrowing emerges as a buffer that assists the bank in smoothing intertemporal adjustments in interdependent loan and deposit choices. The bank smooths the impact of interest-rates shocks on its customers to minimize the adjustments over time of the stocks of deposits and loans. It does not, however, provide insurance against negative shocks of real origin that increase its expected default costs. The predictions of the model help to shed light on the available empirical evidence and to analyze some recent developments of the banking industry.     

How do banks adjust to changing input prices? A dynamic analysis of U.S. commercial banks before and after the crisis

The 2000–2013 period was characterized by substantial regulatory, monetary and technological change, especially after the onset of the global financial crisis. This study assesses the total impact of these policy shifts and technological changes on U.S. commercial banks’ short-run and long-run substitution elasticities. An endogenous-break test divides the sample into a pre-crisis period and a (post-) crisis period. During the former period, banks’ inputs tend to be inelastic substitutes. After the onset of the crisis, particularly the long-run substitutability of most input factors decreases to even lower levels due to changes in both cost technology and economic conditions. At the same time, banks’ response to input price changes becomes more sluggish. Hence, especially after the onset of the crisis, banks have little flexibility regarding input factor usage and are thus sensitive to input price changes from a cost perspective.     

Determinants of the capital adequacy ratio of foreign banks’ subsidiaries: The role of interbank market and regulation

This paper examines the factors influencing the capital adequacy ratio (CAR) of foreign banks. We test whether the CAR of subsidiaries and branches in developed and developing countries depends on the same factors. We use data from 310 subsidiaries and 265 branches to test the impact of the parent banks’ fundamentals on subsidiaries’ and branches’ capital ratios. We also study how the economic condition and regulatory environment in a bank's home country determine foreign banks’ CAR. Our results provide strong evidence that the CAR of subsidiaries and branches operating in developing and developed countries do not depend on the same set of explanatory factors. We also find that the regulatory framework of a parent bank's home country affects the capitalization of its foreign subsidiaries in the host countries. Finally, we show that specific variables of the parent bank have a stronger effect for foreign banks highly related to the interbank market.     

Are stock market crises contagious? The role of crisis definitions

Financial contagion studies generally examine whether co-movement between markets increases during a crisis. We use a flexible co-movement measure to examine how conclusions of such analyses depend on the sample chosen as the ‘crisis’. To this end, we analyse stock market co-movement during the 1997 Asian crisis and the 2007 global financial crisis for all possible source countries and for all possible time periods or extreme return quantiles. This way we account for the main crisis dating approaches adopted in the literature. Our results suggest there is no clear relationship between excess co-movement and commonly used crisis samples.     

Can hedge funds time market liquidity?

We explore a new dimension of fund managers' timing ability by examining whether they can time market liquidity through adjusting their portfolios' market exposure as aggregate liquidity conditions change. Using a large sample of hedge funds, we find strong evidence of liquidity timing. A bootstrap analysis suggests that top-ranked liquidity timers cannot be attributed to pure luck. In out-of-sample tests, top liquidity timers outperform bottom timers by 4.0–5.5% annually on a risk-adjusted basis. We also find that it is important to distinguish liquidity timing from liquidity reaction, which primarily relies on public information. Our results are robust to alternative explanations, hedge fund data biases, and the use of alternative timing models, risk factors, and liquidity measures. The findings highlight the importance of understanding and incorporating market liquidity conditions in investment decision making.     

Do banks price their informational monopoly?

Theory suggests that banks’ private information lets them hold up borrowers for higher interest rates. Since new information about a firm is revealed at the time of its bond IPO, it follows that banks will be forced to adjust their loan interest rates downwards after firms undertake their bond IPO. We test this hypothesis and find that firms are able to borrow at lower interest rates after their bond IPO. Importantly, firms that get their first credit rating at the time of their bond IPO benefit from larger interest rate savings than those that already had a credit rating. These findings provide support for the hypothesis that banks price their informational monopoly. We also find that it is costly for firms to enter the public bond market.     

Do mutual fund managers time market liquidity?

This paper examines mutual fund managers' ability to time market-wide liquidity. Using the CRSP mutual fund database, we find strong evidence that over the 1974–2009 period, mutual fund managers demonstrate the ability to time market liquidity at both the portfolio level and the individual fund level. Liquidity timing predicts future fund performance and the difference in the risk-adjusted returns between top and bottom liquidity-timing funds is approximately 2% per year. Funds exhibiting liquidity-timing ability tend to have longer histories, higher expense ratios, and higher turnover rates.     

How do designated market makers create value for small-caps?

A poor liquidity level and a high liquidity risk significantly raise the required return for small-cap stocks. Euronext allows these firms to hire designated market makers (DMMs) who guarantee a minimum liquidity supply for a lump sum annual fee. In an event study based on 74 DMM stocks, we find that the contract improves liquidity level, reduces liquidity risk, and generates an average abnormal return of 3.5%. DMMs participate in more trades and incur a trading loss on high quoted-spread days (days when their constraint is likely to bind). Finally, DMMs reduce the size of pricing errors.     

Are hedge funds active market liquidity timers?

This paper investigates liquidity timing behaviour of hedge funds that invest globally in foreign investment assets. We expect these hedge funds to manage currencies exposure differently, depending on the extent they treat them as an asset class. In this paper, we investigate if actively timing foreign exchange (FX) liquidity adds value to hedge funds' investments. Unlike the existing studies where fund managers are assumed to either time or not time the market over the entire study period, we argue that fund managers may strategically choose to be active market liquidity timers based on the market condition at the time. To test this hypothesis, we develop a state-dependent liquidity timing model embedded with a Markov regime switching process and identify changes in the FX liquidity timing behaviour among the Global Derivatives hedge funds over an eighteen-year period. Our findings reveal that such regime changes in timing behaviour are driven by the underlying FX liquidity condition. A further analysis to compare the changes in the timing behaviour over time shows that hedge funds that are active market liquidity timers outperform those that engage in liquidity timing less frequently in all strategies categories.     

Did the financial crisis affect the market valuation of large systemic U.S. banks?

We examine the impact of the financial crisis on the stock market valuation of large and systemic U.S. bank holding companies (BHCs). Using the Bertsatos and Sakellaris (2016) model of fundamental valuation of bank equity, we provide evidence that the financial crisis has not altered investors’ attitudes towards bank characteristics. In particular, before, during, and after the crisis, investors in large and systemic U.S. BHCs seemed to penalize leverage, albeit temporarily. Both before and after the crisis, they reward size in the short run. This pattern is appearing only briefly during the crisis. We also show that bank opacity plays no role in market valuation either in the short run or in the long run. Last but not least, we find evidence that stress testing has been informative to the market and that those BHCs that failed at the post-crisis stress tests were not subsequently valued differently by the market.     

How do UK financial institutions really price their banking products?

This paper has several objectives. The first is to explore the type (or types) of imperfect competition that prevailed in the retail banking sector in the 1990s. A general linearised pricing model is employed to test for the degree to which competition in certain markets deviated from the competitive ideal. The key finding, is that, with the exception of mortgage products, deposit and loan rate setting by UK financial institutions is best described by the Salop–Stiglitz model of monopolistic competition, with bargain and rip-offs. Cournot type behaviour is evident in some cases. Indirectly, the presence of perfect contestability is largely ruled out. Another objective is to compare these findings with the results of a similar study conducted nearly a decade ago, when financial reforms introduced to encourage greater competition were relatively recent. Based on the results of this study, the policy lesson is that financial firms exhibit different types of price setting behaviour depending on the banking product. The policy implication is to require firms to produce comparable information for consumers, thereby helping to contain the loss of consumer surplus in imperfectly competitive markets.     

How do nonprofits respond to negative wealth shocks? The impact of the 2008 stock market collapse on hospitals

The theory of cost shifting posits that nonprofit firms “share the pain” of negative financial shocks with their stakeholders, for example, by raising prices. We examine how nonprofit hospitals responded to the sharp reductions in their assets caused by the 2008 stock market collapse. The average hospital did not raise prices, but hospitals with substantial market power did cost shift in this way. We find no evidence that hospitals reduced treatment costs. Hospitals eliminated but left unchanged their offerings of profitable services. Taken together, our results provide mixed evidence on whether nonprofits behave differently from for‐profits.