Funding Liquidity and Its Risk Premium

Abstract

This paper presents a new approach to measure funding liquidity. The key idea is that, as borrowing constraints become more binding, speculators first withdraw from small stocks and then from large stocks since large stocks require lower margins. Given the speculators' role in liquidity provision, the asset liquidity of large and small stocks would covary differently with shocks to speculators' capital depending on their participation in the markets. Based on the intuition, funding liquidity is measured as the difference of rolling correlations of stock market returns with large and small stocks' asset liquidity. The estimated funding liquidity appears to be highly correlated with aggregate hedge fund leverage ratios, broker-dealers' asset growth rates, bond liquidity premia and the percentage of loan officers tightening credit standards. Funding liquidity can also predict GDP growth rates and aggregate stock market returns with strong significance in both in-sample and out-of-sample tests. It is also robust to various equity premium predictors, subsample periods, and long-horizon forecast bias.

Keywords: flight to quality, liquidity, risk premium, predictability