Funding Illiquidity, Funding Risk, and Global Stock Returns

Abstract

We test the role of funding-constrained investors across developed financial markets. We compile direct measures of the severity of funding frictions, or illiquidity, from deviations of government bond yields from a fitted yield curve. Using these illiquidity measures, we first show that higher illiquidity is associated with a flatter security market line across markets. Exploiting the cross-section, we find that cross-country variation in illiquidity is associated with cross-country variation in alpha, in line with our theoretical predictions. Finally, we estimate a significant negative illiquidity risk premium that reveals a strong willingness of investors to hedge against the deterioration of funding conditions.

Keywords: Liquidity, Market Frictions, Capital Constraints, International CAPM

JEL Classification: G11, G12, G15, F31