Working Paper: NBER ID: w16468
Authors: Xing Hu; Jun Pan; Jiang Wang
Abstract: We propose a broad measure of liquidity for the overall financial market by exploiting its connection with the amount of arbitrage capital in the market and the potential impact on price deviations in US Treasurys. When arbitrage capital is abundant, we expect the arbitrage forces to smooth out the Treasury yield curve and keep the dispersion low. During market crises, the shortage of arbitrage capital leaves the yields to move more freely relative to the curve, resulting in more "noise.'' As such, noise in the Treasury market can be informative and we expect this information about liquidity to reflect the broad market conditions because of the central importance of the Treasury market and its low intrinsic noise -- high liquidity and low credit risk. Indeed, we find that our "noise'' measure captures episodes of liquidity crises of different origins and magnitudes and is also related to other known liquidity proxies. Moreover, using it as a priced risk factor helps explain cross-sectional returns on hedge funds and currency carry trades, both known to be sensitive to the general liquidity conditions of the market.
Keywords: Liquidity; Arbitrage Capital; Noise Measure; Market Crises
JEL Codes: G00
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| abundance of arbitrage capital (G19) | reduced noise in treasury yields (E43) |
| reduced noise in treasury yields (E43) | stabilized prices around fundamental values (P22) |
| scarcity of arbitrage capital (G19) | increased noise (R41) |
| increased noise (R41) | higher illiquidity (G19) |
| noise (Q53) | signals liquidity conditions of the overall market (E44) |
| noise measure (C58) | captures liquidity crises (G01) |
| noise measure (C58) | sensitive hedge fund returns (G11) |
| noise measure (C58) | sensitive currency carry trade returns (F31) |
| increased noise (R41) | negative performance in hedge funds during liquidity crises (G01) |
| liquidity risk premium (G33) | significant for funds with high exposure to liquidity risks (G33) |