Market Liquidity and Funding Liquidity
Lasse Heje Pedersen
AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)
Markus K. Brunnermeier
Princeton University - Department of Economics
AFA 2006 Boston Meetings Paper
We provide a model that links a security's market liquidity --- i.e., the ease of trading it --- and traders' funding liquidity --- i.e., their availability of funds. Traders provide market liquidity and their ability to do so depends on their funding, that is, their capital and the margins charged by their financiers. In times of crisis, reductions in market liquidity and funding liquidity are mutually reinforcing, leading to a liquidity spiral. The model provides a natural explanation for the empirically documented features that market liquidity: (i) periodically dries up, (ii) has commonality across securities, (iii) is related to volatility, (iv) experiences flight to liquidity events, and (v) comoves with the market. Finally, the model shows how the Fed can improve current market liquidity by committing to improve funding in a potential future crisis.
Number of Pages in PDF File: 29
Keywords: Liquidity, risk management, systemic risk, haircuts, margins
JEL Classification: G1, G2
Date posted: March 22, 2005
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