An Asset Pricing Approach to Liquidity Effects in Corporate Bond Markets

This paper provides evidence of the impact of hedge funds on asset markets. We construct a simple measure of the aggregate illiquidity of hedge fund portfolios, based on the cross-sectional average …rst order autocorrelation coe¢ cient of hedge fund returns, and show that it has strong and robust in-and out-of-sample forecasting power for 72 portfolios of international equities, corporate bonds, and currencies over the 1994 to 2013 period. The forecasting ability of hedge fund illiquidity for asset returns is in most cases greater than, and provides independent information relative to, well-known predictive variables for each of these asset classes. We rationalize these …ndings using a simple equilibrium model in which hedge funds provide liquidity in asset markets.We thank Gavin Boyle, John Campbell, Wayne Ferson, Thierry Foucault, Rene Garcia, Andrew Lo, Narayan Naik, Martin Luehrmann, Kevin Sheppard, Denitsa Stefanova, Marta Szymanowska, David Thesmar, Dimitri Vayanos, Mungo Wilson, and seminar participants at the 2014 FMA Napa Conference, the 6th Annual Hedge Fund Research Conference in Paris, Erasmus University, HEC Paris, Imperial College, the Inquire UK and LBS Joint Conference, INSEAD, the Luxembourg Asset Management Summit, the Oxford-Man Institute of Quantitative Finance, Saïd Business School and the University of Sydney for helpful discussions and comments.y Kruttli is at Oxford-Man Institute of Quantitative Finance. Email: mathias.kruttli@gmail.com. Part of Kruttli's work on this paper was completed while being at Department of Economics, Oxford University. Patton is at Department of Economics, Duke University, and Oxford-Man Institute of Quantitative Finance. Email: andrew.patton@duke.edu. Part of Patton's work on this paper was completed while visiting the Discipline of Finance at the University of Sydney. Ramadorai is at Saïd Business School, Oxford University, Oxford-Man Institute, and CEPR. Email: tarun.ramadorai@sbs.ox.ac.uk. The Impact of Hedge Funds on Asset MarketsABSTRACT This paper provides evidence of the impact of hedge funds on asset markets. We construct a simple measure of the aggregate illiquidity of hedge fund portfolios, based on the cross-sectional average …rst order autocorrelation coe¢ cient of hedge fund returns, and show that it has strong and robust in-and out-of-sample forecasting power for 72 portfolios of international equities, corporate bonds, and currencies over the 1994 to 2013 period. The forecasting ability of hedge fund illiquidity for asset returns is in most cases greater than, and provides independent information relative to, well-known predictive variables for each of these asset classes. We rationalize these …ndings using a simple equilibrium model in which hedge funds provide liquidity in asset markets.

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“…In the Internet Appendix we consider alternative competitors proposed by Bongaerts, de Jong, and Driessen (2012).…”

Section: Asset Return Datamentioning

confidence: 99%

“…We view this new variable as a complement to a number of asset-class-speci…c liquidity measures (see, for example, Acharya and Pedersen (2005), Pastor and Stambaugh (2003), Khandani andLo (2011), andBongaerts, de Jong, andDriessen (2012)) that have been utilized extensively in the literature.…”

Section: Introductionmentioning

confidence: 99%

The Impact of Hedge Funds on Asset Markets

Kruttli

Patton

Ramadorai

2015

Rev Asset Pric Stud

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“…However, the corporate bond market provides an ideal laboratory because the credit rating of a bond is a good indicator of its "quality," whereas within the same rating category, large variations in bond liquidity remain. We obtain estimates of returns and transaction costs on credit quality-and liquidity-sorted US corporate bond portfolios from Bongaerts et al (2017 Edwards et al (2007). Bongaerts et al (2017) show that the variation in the transaction costs across bonds is best explained by the "amount issued" characteristic; we therefore use "amount issued" as our liquidity measure.…”

Section: Fts and The Cross Section Of Corporate Bondsmentioning

confidence: 99%

“…We obtain estimates of returns and transaction costs on credit quality-and liquidity-sorted US corporate bond portfolios from Bongaerts et al (2017 Edwards et al (2007). Bongaerts et al (2017) show that the variation in the transaction costs across bonds is best explained by the "amount issued" characteristic; we therefore use "amount issued" as our liquidity measure. For credit quality, we focus on the EDF proxy, but show additional results using the credit ratings proxy in the Online Appendix.…”

Section: Fts and The Cross Section Of Corporate Bondsmentioning

confidence: 99%

Flights to Safety

Baele¹,

Bekaert²,

Inghelbrecht³

et al. 2013

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We are particularly grateful to Frank de Jong for sharing his corporate bond market dataset with us and Zilong Niu for his excellent research assistance with the construction of the quality/liquidity sorted equity portfolios. Baele, Bekaert, and Inghelbrecht gratefully acknowledge financial support from the National Bank of Belgium and Inquire Europe. Bekaert acknowledges financial support from Netspar. The opinions expressed are those of the authors and do not necessarily reflect views of the National Bank of Belgium, the Federal Reserve System, or the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

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“…However, empirically, there is a lack of consensus on the importance of expected liquidity versus liquidity risk in returns. In corporate bond markets, Lin, Wang and Wu (2011) find that liquidity risk premia can help to explain corporate bond returns, whereas Bongaerts, de Jong, and Driessen (2013) find that liquidity risk is priced in equity markets but not in corporate bond markets.…”

mentioning

confidence: 99%

Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads

Schwarz

2010

SSRN Journal

117

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Wide and volatile interest rate spreads in the 2007-2009 financial crisis could represent concerns over asset liquidity or issuer solvency. To precisely identify the contribution of these two effects on sovereign bond and interbank spreads, I propose a model-free measure of euro-area market liquidity that captures all liquidity information impounded in bond yields. I find that credit and liquidity are independently important in risk spreads; the role of liquidity dominates in the interbank market, while its relative importance in sovereign bond spreads varies substantially by country. I exploit variation in sovereign bond returns over countries, maturities and time to directly test liquidity risk pricing; the possibility that liquidity could be negatively correlated with marginal utility. I find that liquidity risk premia are large and significant, evidencing the importance of a liquidity channel missed by measures that capture only instantaneous liquidity.Keywords market liquidity, interbank credit, liquidity risk, money markets, interest rates, financial crisis Disciplines Finance and Financial ManagementThis working paper is available at ScholarlyCommons: http://repository.upenn.edu/fnce_papers/19Electronic copy available at: https://ssrn.com/abstract=1486240 Mind the Gap: Disentangling Credit and Liquidity in Risk SpreadsKrista Schwarz *The Wharton School University of Pennsylvania February 2017 AbstractWide and volatile interest rate spreads in the 2007-2009 financial crisis could represent concerns over asset liquidity or issuer solvency. To precisely identify the contribution of these two effects on sovereign bond and interbank spreads, I propose a model-free measure of euro-area market liquidity that captures all liquidity information impounded in bond yields. I find that credit and liquidity are independently important in risk spreads; the role of liquidity dominates in the interbank market, while its relative importance in sovereign bond spreads varies substantially by country. I exploit variation in sovereign bond returns over countries, maturities and time to directly test liquidity risk pricing; the possibility that liquidity could be negatively correlated with marginal utility. I find that liquidity risk premia are large and significant, evidencing the importance of a liquidity channel missed by measures that capture only instantaneous liquidity.JEL Classification: E44, G01, G12, G15 Keywords: market liquidity, interbank credit, liquidity risk, money markets, interest rates, financial crisis. * Department of Finance, The Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia, PA 19104. Tel. 215-898-6087. E-mail: kschwarz@wharton.upenn.edu. I am grateful to an anonymous referee, Heitor Almeida, Andrew Ang, Charles Calomiris, Larry Glosten, Charles Jones, Ahn Le, Francis Longstaff and Suresh Sundaresan for their extremely helpful comments on this work, to the Department of Economics and Finance at Columbia Business School for funding the MTS data used in this paper, and t...

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An Asset Pricing Approach to Liquidity Effects in Corporate Bond Markets

Cited by 16 publications

References 23 publications

The Impact of Hedge Funds on Asset Markets

The Impact of Hedge Funds on Asset Markets

Flights to Safety

Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads

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