Review of Financial Studies 25(4), 2012.
Funding Risk Factor updated to December 2013
With René Garcia at the EDHEC Business School. Our main contribution is to show that the value of funding liquidity is an aggregate risk factor driving a substantial share of risk premia across fixed-income markets. The paper can be found here : Bond Liquidity Premia, here is the online appendix and the abstract follows.
Here is the factors used in the published version of the paper: FundingLiquidityFactor19862009. The updated funding liquidity and term structure factors can be found here: FundingLiquiditFactor_19862015Q4. These factors are obtained using the model in the paper above, but re-estimated with recent data. The funding liquidity factor is standardized to a mean of zero and standard deviation of one. Strikingly, using parameters estimated using recent data yield very similar results to that usin data until to the end of 2007 (as in the paper). This Figure –CompareFundingLiquidityFactors– compares the series obtained with data until 2007, 2009 and 2012. The model continue to perform exceptionally well out-of-sample.
Asset pricing models of limits to arbitrage emphasize the role of funding conditions faced by financial intermediaries. In the US, the Treasury repo market is the key funding market and, hence, theory predicts that the liquidity premium of Treasury bonds share a funding liquidity component with risk premia in other markets. We identify and measure the value of funding liquidity from the cross-section of bonds by adding a liquidity factor correlated with age to an arbitrage-free term structure model. We validate our interpretation of this funding liquidity factor by establishing its linkages with other measures of funding conditions at three different levels of aggregation. Looking at asset pricing implications, we find that an increase in the value of liquidity predicts lower risk premia for on-the-run and off-the-run bonds but higher risk premia on LIBOR loans, swap contracts and corporate bonds. The impact is large and pervasive through crisis and normal times. Conditions on funding markets have a first-order impact on interest rates.