International Illiquidity

Abstract

We build a parsimonious international asset pricing model in which deviations of government bond yields from a fitted yield curve of a country measure the tightness of investors' capital constraints. We compute these measures at daily frequency for six major markets and use them to test the modelpredicted effect of funding conditions on asset prices internationally. Global illiquidity lowers the slope and increases the intercept of the international security market line. Local illiquidity helps explain the variation in alphas, Sharpe ratios, and the performance of betting-against-beta (BAB) strategies across countries. The recent financial crisis has dramatically illustrated how market frictions can impede orderly investment activity and have significant effects on asset prices.1 These phenomena are even more prominent when looking at asset prices in an international context where specialized institutions, such as hedge funds and investment banks, are responsible for a large fraction of active cross-country investments. In order to understand the specific mechanisms at work and to test various friction-based asset pricing theories, researchers and policymakers alike require economically-motivated indicators of market stress.In this paper, we study the effect of frictions, such as funding constraints or barriers that impede smooth cross-border movement of capital, on asset prices internationally.We generically refer to the tightness of these frictions as illiquidity. Our contribution to the existing literature is threefold. First, we develop a parsimonious international asset pricing model with constrained investors who trade in equity and bond markets globally.Second, we construct model-implied proxies for country-level and global illiquidity from daily bond market data of six developed countries. Third, in line with the model predictions, we find that global illiquidity affects the international risk-return trade-off by lowering the slope and increasing the intercept of the international security market line, stocks in countries with higher local illiquidity earn higher alphas and Sharpe ratios, and, as a result, accounting for the cross-country differences in illiquidity improves on the performance of traditional betting-against-beta (BAB) type strategies.We measure illiquidity as the average squared deviation of observed government bond prices from those implied by a smooth fitted yield curve. This approach has been proposed by Hu, Pan, and Wang (2013), who argue that "noise" in the US Treasury yield curve contains a strong signal about the general scarcity of investment capital in financial markets. Government bonds are particularly well suited in this context because they are among the safest and most liquid assets, they are actively traded for investment purposes, and they are used as the main source of collateral to obtain funding.Moreover, their prices are known to be well described by a simple factor structure during normal times. In our model bond price deviations emerge in equilibrium because ...

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