Noise as Information for Illiquidity

70 Pages Posted: 9 Oct 2010 Last revised: 25 Sep 2012

See all articles by Grace Xing Hu

Grace Xing Hu

PBC School of Finance, Tsinghua University

Jun Pan

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF); National Bureau of Economic Research (NBER); China Academy of Financial Research (CAFR)

Jiang Wang

Massachusetts Institute of Technology (MIT) - Sloan School of Management; China Academy of Financial Research (CAFR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: September 11, 2012

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.

Suggested Citation

Hu, Grace Xing and Pan, Jun and Wang, Jiang, Noise as Information for Illiquidity (September 11, 2012). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1689067 or http://dx.doi.org/10.2139/ssrn.1689067

Grace Xing Hu

PBC School of Finance, Tsinghua University ( email )

43 Chengfu Road
Haidian District
Beijing, Beijing 100083
China

Jun Pan (Contact Author)

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

Jiang Wang

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E62-614
100 Main Street
Cambridge, MA 02142
United States
617-253-2632 (Phone)
617-258-6855 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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