Market liquidity | EPFL Graph Search

In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the price at which an asset can be sold, and how quickly it can be sold. In a liquid market, the trade-off is mild: one can sell quickly without having to accept a significantly lower price. In a relatively illiquid market, an asset must be discounted in order to sell quickly. Money, or cash, is the most liquid asset because it can be exchanged for goods and services instantly at face value. Overview A liquid asset has some or all of the following features: It can be sold rapidly, with minimal loss of value, anytime within market hours. The essential characteristic of a liquid market is that there are always ready and willing buyers and sellers. It is similar to, but distinct from, market depth, which relates t

Essays on the Market Structure and Pricing of Credit Derivatives

Jan Benjamin Junge

This thesis analyzes the interrelation between market structure and price formation in credit derivatives markets. Traditionally, credit derivatives are traded in relatively opaque over-the-counter markets in which trading is segmented and subject to many imperfections from which illiquidity may arise. Recent regulatory reforms have brought transparency to some credit derivatives markets without affecting their segmented structures. The first chapter, which is joint work with Anders B. Trolle, analyzes whether liquidity risk is priced in the cross section of returns on credit default swaps (CDSs). The analysis is based on a factor pricing model and a tradable liquidity factor that is constructed from returns on index arbitrage strategies. The underlying presumption is that violations of simple no-arbitrage relations between different CDS contracts reflect constraints on the risk-bearing capacity of CDS market intermediaries and, in broad terms, CDS market illiquidity. The analysis reveals priced liquidity risk in that credit protection sellers earn higher expected excess returns on CDS contracts with higher liquidity exposures. The liquidity risk premium is significant and accounts for 24% of CDS spreads, on average. CDS risk premia correlate negatively with proxies for the risk-bearing capacity of CDS market intermediaries, which is consistent with intermediary frictions affecting the pricing of CDSs. The second chapter, which is joint work with Pierre Collin-Dufresne and Anders B. Trolle, analyzes transaction costs in the dealer-to-customer (D2C) and dealer-to-dealer (D2D) segments of the post-Dodd-Frank index CDS market. Dodd-Frank regulations that made all-to-all trading possible had the potential to break up the market's segmented structure but failed to do so. This led to a controversy with some market participants arguing that the segmented structure is optimal and other market participants arguing that dealers maintain the segmented structure in order to limit competition by alternative liquidity providers. The analysis reveals that D2C trades indeed have larger transaction costs than D2D trades but that the differences in transaction costs reflect differences in price impacts rather than differences in profits from liquidity provision. D2C trades are even competitive relative to executable bids and offers in the D2D segment, suggesting that the market structure delivers favorable prices for customers who value immediacy. The third chapter documents a decline of transaction costs and profits from liquidity provision in the index CDS market over a two-and-a-half-year period during which Dodd-Frank regulations were implemented. Transaction costs and profits from liquidity provision declined around the introduction of so-called swap execution facilities (SEFs); i.e., regulated trading platforms that offer pre-trade transparent methods of trade execution. Trades that are executed on SEFs have lower transaction costs and are less profitable from a liquidity provider's perspective in comparison to bilaterally negotiated trades, which is consistent with better comparison shopping and stronger price competition on SEFs. Dodd-Frank regulations mandating on-SEF trade execution that were implemented after the introduction of SEFs did not affect transaction costs and profits from liquidity provision, suggesting that there is no incremental effect associated with mandatory pre-trade transparency.

EPFL2016

Three Essays in Banking and Finance

Damien Olivier Klossner

This thesis develops three models that study the motivation of various agents to take on debt, and the impact that excessive financial leverage can have on social welfare. In the chapter "Short-term Bank Leverage and the Value of Liquid Reserves", the incentive of a bank to take on leverage stems from the fact that its short-term debt provides liquidity benefits to depositors, at the cost of exposing the bank to the risk of runs. In the model, a bank possesses two instruments to manage the risk of runs: its funding policy and the size of its liquid asset holdings, modeled as government bonds. Issuing more debt allows the bank to better capture the liquidity benefits fits priced into deposits but increases illiquidity risk. Holding more bonds makes the bank more robust to withdrawals but it reduces the bank's asset returns. When the supply is scarce, banks are the natural buyers of government bonds. This links the liquidity premium priced into government bonds to the risk of bank runs. In the chapter "Liquidity, Debt Overhang, and Monetary Policy", firms take on bank credit to relax their liquidity constraint and purchase new capital. But taking on debt creates a debt overhang distortion which causes entrepreneurs to pass on protable projects. In the model, entrepreneurs arrange for their financing before they observe the profitability of their investment opportunity. After the latter becomes known, entrepreneurs are liquidity-constrained when investment conditions are favorable, and over-indebted when they are unfavorable. The monetary authority can generate welfare gains by lowering the cost of holding liquidity and, when debt is contracted in nominal terms, by pursuing a counter-cyclical monetary policy. In the chapter "Safe Claim Production and Capital Structure", firms issue debt to satisfy the demand of risk-averse investors for safe claims, at the cost of increasing default risk. In general equilibrium, firms need to be compensated for this service, which can only occur if their debt and equity claims are held and priced by different investor types. This segmentation of the investor base can be sufficient to prevent the existence of a symmetric equilibrium. Instead, only a fraction of firms opt for levered capital structures, and the gain in value obtained by tranching cash flows into debt and equity is offset by the expected cost of default. Changes in aggregate leverage can be divided into variations in extensive (the fraction of levered firms ) and intensive (the leverage ratio of levered firms ) margins. Changes in rm business risk have opposite effects on leverage, depending on whether the risk is of a systematic nature or firm-specific nature.

EPFL2019

Three Problems of Liquidity under Asymmetric Information

Sylvain Jean Pascal Carré

This thesis develops models for three problems of liquidity under asymmetric information. In the chapter "Disclosures, Rollover Risk, and Debt Runs" I build a model of dynamic debt runs without perfect information in order to understand the impact of asset opacity and disclosure policies on run likelihood and economic efficiency. I find that opacity is desirable with respect to both these metrics if and only if fundamentals are strong enough; and that a bank should commit to disclose truthfully any information it has unless the level of opacity is large. The model also uncovers rich interactions between debt dynamics, beliefs dynamics and equilibrium outcomes: short-term yields may remain low while risk builds up in the background, and therefore may not contain a warning sign of an upcoming crisis; and a disclosure regime might produce higher beliefs about collateral quality but nevertheless imply larger financing costs and thus lead to a bank failure. In the chapter "Short-term Bank Leverage and the Value of Liquid Reserves", we extend the modelling toolbox of the global games literature by providing a fully rational setup where liquid reserves are modeled explicitly. The banks' balance sheet decisions and the prices of all securities are endogenous in the model. A bank possesses two instruments to manage illiquidity risk: its funding policy and the size of its liquid asset holdings,modeled as government bonds. Higher short-term indebtness allows the bank to better capture the liquidity benefits priced into deposits but increases illiquidity risk. Holding more bonds makes the bank more robust to withdrawals but it reduces the bank's asset returns. The impact of an increase in bond supply on bank leverage depends on the general-equilibrium change in the cost of absorbing the supply. The model also illustrates how considering an endogenous leverage decision is key to predict the impact of the economic environment on the liquidity premium. In the chapter "Insider Trading under Penalties", we establish existence and uniqueness of equilibrium in a generalised one-period Kyle (1985)model where insider trades can be subject to a size-dependent penalty. The result is obtained by considering uniform instead of Gaussian noise and holds for virtually any penalty function. We apply this result to regulation issues. We show that the penalty functions maximising price informativeness for given noise traders' losses eliminate small rather than large trades. We generalise this result to cases where a budget constraint distorts the set of penalties available to the regulator.

EPFL2019