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This research investigates the effects of shadow banking on the relation between capital and liquidity creation in China's banking industry. We consider three trust beneficiary rights as the proxies for shadow bank activities, which transform risky corporate loans into interbank loans inside the banking system. Findings present that these activities tend to exaggerate the regulatory capital ratios and liquidity creation measures and then distort the relationship between capital and liquidity creation ratios. The result shows that before removing the influence of shadow banking, banks with a lower capital ratio would engage in more liquidity creation, thus supporting the financial risk-taking hypothesis. By contrast, the risk-absorption hypothesis exists whereby banks would engage in more liquidity creation when they have a higher capital ratio if we consider the effect of shadow banking. Our study also contributes to policymaking by indicating that a failure to use correct information for the assessments of capital and liquidity creation can lead to false conclusion that China's banks are safe, which further mislead any regulatory policy.

In this article, we account for the liquidity risk in the underlying assets when pricing European exchange options, which has not been considered in the literature. An Ornstein-Uhlenbeck process with the mean -reversion property is selected to model the market liquidity risk, whose impacts on the underlying assets are assumed to be imposed with a liquidity discount factor. Under this framework, we develop a simplified approach to obtain the pricing formula, a distinguishing feature of which is that it does not require any numeraire change. We first transform the exchange option's pricing PDE into a pricing PDE of the European vanilla option, which is then solved in closed-form using the characteristic function approach. Finally, we present accuracy tests and sensitivity analysis to demonstrate the correctness of the formula and the influence of introducing the liquidity risk on exchange options, respectively.

We model competition for liquidity provision between high-frequency traders (HFTs) and slower execution algorithms (EAs) designed to minimize investors’ transaction costs. Under continuous pricing, EAs dominate liquidity provision by using aggressive limit orders to stimulate HFTs’ market orders. Under discrete pricing, HFTs dominate liquidity provision if the bid-ask spread is binding at one tick. If the tick size (minimum price variation) is not binding, EAs choose between stimulating HFTs and providing liquidity to non-HFTs. Transaction costs increase with the tick size but can be negatively correlated with the bid-ask spread when all traders can provide liquidity. This research is supported by National Science Foundation grant 1,352,936 (jointly with the Office of Financial Research at the US Department of the Treasury) and National Science Foundation grant 1,838,183.

We analyze the hoarding of reserves by Sub-Saharan African (SSA) banks while nonfinancial firms struggle to access credit. Using country-level data, we show that SSA bank reserves are structurally associated with insufficient credit demand. We highlight asymmetric liquidity management practices, where banks hoard reserves in low demand states, while states of excess demand are not associated to decreasing reserves. Moreover, liquid assets holdings are related to the extent of disequilibrium on credit markets, possibly reflecting a rationing behavior in states of excess demand. We do not confirm the usually alleged precautionary motive for reserves holdings based on deposit volatility. However, SSA banks, to some extent, manage their liquid assets buffers to withstand repeated episodes of deposit outflows. Our results suggest that the structural policies facilitating the access to the credit market may lead banks to displace the reserves toward the private sector, while short-term risk management concerns might be of secondary importance in explaining reserve hoarding.

This paper derives a liquidity cost process in a non-cooperative cost competition game among market makers and discusses its implication for the structure of a dealer market. The main result shows that there does not exist an equilibrium supporting both multiple market makers earning strictly positive profits and a well-behaved liquidity cost process (i.e. strictly increasing and convex) as documented in the price impact literature. Bertrand price competition arises as an equilibrium phenomenon, which naturally leads to the dominance of a cost-efficient market maker in the dealer market.

Hedging a credit portfolio using single-name credit default swap (CDS) is affected by low liquidity and high spread volatility, which induces continuous changes in a portfolio mark-to-market. As an alternative, we consider hedging a derivative portfolio by taking a contrary position in a credit index, evaluating the empirical market risk that remains after such hedge. We perform three different hedging exercises: for single-names, for sectorial portfolios and for regional portfolios. We implement least squares hedging as a benchmark, and compare its efficiency with a hedge ratio estimated under the RiskMetrics exponentially moving average (EWMA) specification for time varying second order moments, as well as with the hedge ratio obtained from a bivariate GARCH model for the portfolio and the credit index used as a hedge. Over the 2007–2012 period, we find a high hedging efficiency for regional portfolios (Europe, North America and Japan), as well as for a global portfolio, which is back at pre-crisis levels. The EWMA hedge is slightly more efficient than the least-squares hedge, while the GARCH hedge does not improve hedging efficiency. Hedging efficiency is not as high for sectorial credit portfolios from Europe and North America, due to their more important idiosyncratic component. Taking into account the quality of the credit counterpart improves the effectiveness of the hedge, although it requires using less liquid credit indices, with higher transaction costs. This hedging strategy becomes much more complex if firms in the portfolio have a large idiosyncratic component. The efficiency of the hedge is higher when liquidity risk and systematic risk are high, or when the term structure is flat. We also provide evidence suggesting that credit indices can also offer a moderately efficient hedge for corporate bond portfolios, which we have examined with a reduced sample of firms over 2006–2018.

This paper investigates the predictability of foreign exchange (FX) volatility and liquidity risk factors on returns to the carry trade, an investment strategy that borrows in currencies with low interest rates and invests in currencies with high interest rates. Previous studies have suggested that this predictability could have been spuriously accounted for due to the persistence of the predictors. The analysis uses a predictive quantile regression model developed by Lee (2016) that allows for persistent predictors. We find that predictability changes remarkably across the entire distribution of currency excess returns. Predictability weakens substantially in the left tail once persistence is accounted for, implying a moderate negative predictive relation between FX volatility risk and carry trade returns. By contrast, it becomes stronger in the right tail. Furthermore, we provide evidence that FX volatility risk still dominates liquidity risk after controlling for persistence. These findings suggest that the persistence of the predictors needs to be taken into account when one measures predictability in currency markets. Finally, out-of-sample forecast performance is also presented.

The recent asset pricing literature has largely neglected liquidity risk since the price-impact-based factor shows limited pricing ability. Using different liquidity factors, this paper evaluates the liquidity-risk-based models together with the non-liquidity-based ones. With the new testing procedures and the different testing portfolios, we find that the liquidity-augmented capital asset pricing model (LCAPM) performs well. It yields a significant liquidity risk premium robust to all the other models. The success of the LCAPM lies in the fact that the trading-discontinuity-based factor captures the systematic nature of liquidity risk. It shows that liquidity risk is priced highly during the down and turmoil markets, whereas all the other factors examined exhibit insignificant risk prices when market volatility is high. Our evidence indicates that liquidity risk matters and the LCAPM is preferable to use for investment decision making, financial market research and regulation.

Using a network approach, we show how the federal funds market was transformed during the financial crisis through the collapse of the ABCP market in 2007, changes in monetary policy implementation, and an increase in counterparty credit risk. For both aggregate and bank-level network metrics, we find that increases in counterparty and liquidity risk are associated with reduced lending activity within the network. We also provide evidence that network peer effects are strong and influence banks’ holdings of reserve balances and rates paid in the federal funds market. Finally, we document how these changes to the network structure dampened the transmission of monetary policy.

Do stock prices of publicly listed companies respond to changes in transaction costs? Using the SEC’s pilot program that increased the tick size for approximately 1,200 randomly chosen stocks, we find a stock price decrease between 1.75% and 3.2% for small spread stocks affected by the larger tick size relative to a control group. We find that the increase in the present value of transaction costs accounts for a small percentage of the price decrease. We study channels of price variation due to changes in expected returns: information risk, investor horizon, and liquidity risk. The evidence suggests that trading frictions affect the cost of capital.

Corporate bond mutual funds engage in liquidity transformation, raising concerns among academics and policy makers that large redemptions will lead to asset fire sales. We find little evidence, however, that bond fund redemptions drive fire sale price pressure after controlling for time-varying issuer-level information that could also affect funds’ trading decisions, using a novel identification strategy that exploits same-issuer bonds held by funds with differing outflows. We attribute our findings, which contrast with those found for equity funds, to funds’ liquidity management strategies. Bond funds maintain significant liquidity cushions and selectively trade liquid assets, allowing them to absorb investor redemption risk without excessively liquidating corporate bonds, even during the 2008 financial crisis.

We investigate the effect of exchange-traded fund (ETF) liquidity on ETF tracking errors, returns, and volatility in the US. We find that illiquid ETFs have large tracking errors. The effect is more pronounced when underlying assets are less liquid. Returns and liquidity of illiquid ETFs are more sensitive to underlying index returns or ETF market liquidity, or both. Thus, a positive liquidity premium exists in US ETF markets. The ETF variance could be larger than its net asst value variance owing to infrequent trading. In summary, illiquid ETFs are more likely to deviate from their underlying indexes and could be riskier than underlying portfolios.

This research investigates the effect of an unconventional monetary policy, in which we focus on capital liquidity, especially when interest rates enter negative territory. Through covered interest rate parity (CIP), we look to detect how foreign exchange (FOREX) markets are exposed to liquidity risk. With an illustration via Japan’s market, this study applies a dynamic equilibrium model to show how policy change sensitivity affects market efficiency. We discover that there are long-run relationships between the forward premium (discount) and interest rate differential in Japan’s FOREX markets, and some markets fulfill the CIP condition, while others do not. When the interest rate differential closes in on zero, we reveal that liquidity risk significantly rises. Moreover, when interest rates enter negative territory, liquidity risk diminishes. A negative interest rate could lead commercial banks to have higher capital utilization and speed up market liquidity.

This paper tests for the externality of debt in the equity markets. Adopting an exogenous view of the business cycles and assuming myopia amongst borrowers and lenders, the paper argues that when the markets are going up, portfolios and indices with high debt should perform better than those with low debt, while during the downward phase, low debt portfolios and indices would perform better. We use firm as well as index level data to compare performance based on high and low debt in the up and down market and conduct a series of robustness tests. We use monthly data from 2555 listed nonfinancial US firms from 1982 to 2016 to create low and high debt portfolios. At the index level, we use Islamic indices as a proxy for low debt indices. Our results show that low debt portfolio and Islamic indices outperform the high debt portfolio and conventional indices in the down market and underperform in the up market, respectively. The paper contributes to the literature on debt externality by extending the idea to the equity markets. The paper also contributes to the Islamic finance literature by identifying their better performance in the down markets. We theorize that the low debt of Islamic equity indices could be the moderating cause of their better performance.

This paper studies the relationships between both liquidity and credit risks on bank stability for a panel data set of 75 conventional banks belonging to 11 countries of the MENA region observed during the period 1999–2017. By performing a Panel Smooth Threshold Regression (PSTR) model developed by Gonzalez et al. (2005) , estimation results show that the relationships between bank stability-credit risk and bank stability-liquidity risk are non-linear and characterized by the presence of two optimal thresholds which are equal to 13.16% for credit risk and 19.03% for liquidity risk. Contrary to their positive effects below these optimal thresholds, credit risk and liquidity risk become detrimental to bank stability in high regime. To ensure their stability, banks are encouraged to revise the primacy given to credit activity and diversify their activities to improve profitability. They are also recommended to strengthen their own funds and opt for appropriate restructuring to ease their small size. As for the States of the selected countries, they have to deeply reform their financial systems and develop the legal framework relating to new techniques of external management of banking risks including securitization and defeasance. Likewise, these states are fortified to ensure political stability, which is a key factor for banking and financial stability.

We model the joint dynamics of intraday liquidity, volume, and volatility in the U.S. Treasury market, especially through the 2007–09 financial crisis and around important economic announcements. Using various specifications based on Bauwens and Giot (2000)’s Log-ACD(1,1) model, we find that liquidity, volume, and volatility are highly persistent, with volatility having a lower short-term persistence than the other two. Market liquidity and volume are important to explaining volatility dynamics but not vice versa. In addition, market dynamics change during the financial crisis, with all variables exhibiting increased responsiveness to their most recent realizations. Our models also reveal different market dynamics around announcements. Finally, we introduce new measures of liquidity risk that are useful for continually monitoring liquidity conditions and the risk of liquidity stress in the market.

We propose four factors, including carry, momentum, value as well as currency market risk factors in a risk-based asset pricing framework. By examining currency portfolios through time series and cross-sectional asset pricing, we validate that the four-factor model is capable of capturing the excess returns to these portfolios. Next, to understand the economic forces behind the carry, momentum and value factors, we investigate the linkages of these three factors to several fundamental variables. Our results indicate that the carry factor is linked to innovations in equity volatility and liquidity risk, whilst the momentum one is linked to innovations in equity volatility, funding liquidity risk and lagged short rate, whereas the value factor is linked to innovations in equity volatility, lagged term spread and lagged default spread. Whilst investors require compensation for a carry strategy that performs poorly when global market conditions deteriorate, they will pay for a momentum strategy that performs well under these circumstances. Positive innovations in equity volatility, an increase in funding liquidity risk and lagged short rate are good proxies for such periods.

The new prudential regulation framework, established by the European Central Bank (ECB) after the financial crisis encompasses supervisory procedures to measure and monitor bank business models, capital requirements, governance arrangements and liquidity risk. However, research on financial stability has revealed that, during financial crises, it would have been essential to monitor the vulnerability of banks by also assessing the value of their intangible assets. We contribute to the extant literature by examining the impact of a specific intangible asset—namely, managerial ability—on bank risk-taking. Given the interest of the regulatory authority in monitoring financial stability, we quantify management ability and document its double effects on bank risk-taking: the indirect effect through franchise value and its direct effect. We examine a sample of listed banks from 15 EU countries over the period 1997–2016. We find that higher managerial ability is associated with higher franchise value, contributing to a decrease in bank risk-taking (indirect effect), particularly for small banks and during financial crisis. Moreover, managerial ability reduces bank risk-taking through its direct effect. Our evidence suggests that managerial ability could be considered a measure (easily estimated) for regulating the disciplinary role of franchise value and, used in combination with current regulatory measures, could lead to supervisors achieving more effective management oversight.

We construct a bottom-up simulation model that draws on a bank's stylized disaggregated balance sheet to measure the impact of both LCR and NSFR. The constructed balance sheet comprises fixed-income items, stocks, deposits, and off-balance sheet items. The simulation model accounts for credit risk, interest rate risk, and liquidity risk including their interactions. Regarding bank liquidity risk, the model accounts for withdrawal risk in non-maturing deposits, the call-off risk of irrevocably committed credit lines and market price risk of assets. Our main results are summarized as follows: First, the introduction of LCR and NSFR has no unambiguous impact on bank's equity return and balance sheet growth. Second, the introduction of the liquidity ratios helps to reduce default risk. Third, it is more difficult for banks to comply with the ratios’ thresholds in macroeconomic stress scenarios than in other scenarios. Fourth, the reduction of maturity transformation can effectively close liquidity gaps within one year. However, this comes at the cost of a higher frequency of future negative net cash flows above one year.

This paper examines the effects of bond liquidity on firms’ investments. We postulate that bond liquidity increases firms’ investment opportunities by reducing the cost of capital and improving access to financing. Using the variation in liquidity generated by several positive and negative exogenous shocks, we find that firms respond to positive (negative) shocks by expanding (contracting) capital expenditures and acquisition activity. Further, by enhancing access to funding, bond liquidity facilitates acquisition financing and reduces the likelihood of investment delays. Notably, we find a positive impact of bond liquidity on market valuations and profitability, suggesting that these investments are value-increasing.

Because of their opaque nature, SMEs are overly reliant on bank lending. Therefore, we examine whether banks' credit supply to SMEs are affected by their financial conditions. To this end, we employ a Granger causality analysis to examine whether there is an indication of a significant direction of determination between SME lending and non-performing SME loans. The results reveal no bidirectional relationship between SME lending and NPL for the entire banking sector. For Islamic banks, however, we find two-way linkages between these two parameters: a negative causation is running both from SME lending to NPL growth and from NPL to SME lending. Given Islamic banks' deposit-oriented funding practices and their adherence to profit-and-loss sharing principles, this finding suggests the presence of heightened market discipline within the Islamic banking system.

The paper presents an agent-based model to study the interaction between income inequality and prudential regulations in a macroeconomic framework characterized by consumer debt. Simulation results show that income inequality is detrimental to both macro and financial stability as it leads to higher credit demands, higher unemployment rates, economic volatility, and financial fragility. Besides the importance of consumers' leveraging, deleveraging externalities are found to be equally important for the emergence of crises and financial fragility because of the liquidity risk they entail. Minsky moments are also observed; they are related to consumers' prudential behavior and their beliefs about the macroeconomic conditions. Concerning the policy relevance of our investigation, simulations allow us to highlight that the effectiveness of prudential regulation depends on the phase of the business cycle and that there is not a “one-size-fits-all” regulation. This study emphasizes that regulatory constraints should take into account the features of the economic agents, such as the distribution of income and their willingness to borrow, in addition to the features of the financial sector.

I present a general equilibrium monetary model of banking with multiple equilibria. In the good equilibrium, all banks are solvent. In the bad equilibrium, a fraction of banks in the economy are insolvent and subject to runs. The bad equilibrium is also characterized by deflation and a flight to liquidity, and matches other stylized facts of systemic financial crises. The multiplicity of equilibria arises from a strategic complementarity in the decision to fly to liquidity. A sufficiently large monetary injection eliminates the bad equilibrium. However, the size of the monetary injection required to eliminate the equilibrium is smaller if the central bank provides loans to banks, in comparison to using an asset purchase policy. This is because loans to banks are equivalent to asset purchases coupled with partial deposit insurance.

We analyze the impact of market liquidity on bank lending in the euro area over the period 2003–16 and find that market liquidity is positively related to aggregate loan volumes and negatively related to average credit spreads. This relation is stronger during crisis times and asymmetric so as the impact of a reduction in liquidity is more significant. Results are confirmed on the individual bank level and strongest for non-listed and less profitable banks. This implies that properly functioning and sufficiently liquid financial markets are necessary to avoid negative consequences of restrictions in bank lending for the real economy.

We use regression analysis to quantify the impact of investors’ risk perceptions, as measured by VIX, on stock market liquidity in 57 countries. We show that increased risk perception reduces liquidity around the world, and its impact is not subsumed by other well-documented market-level determinants of liquidity. The effect is pervasive, but is stronger in countries with higher GDP per capita, more trade openness, stronger governance, a more individualistic culture, and no short-selling constraints. It is not driven by periods of extreme changes in risk perception, expansionary or recessionary phases of the business cycle, or the way liquidity is measured.

This paper analyzes whether realized higher moments are able to predict out-of-sample sovereign bond returns using high-frequency data from the European bond market. We study bond return predictability over tranquil and crisis periods and across core and periphery markets at the index and country level. We provide fresh evidence that realized kurtosis is the dominant predictor of subsequent returns among higher moments and other predictors such as CDS spreads, short-term interest rates and implied stock market volatility. Our findings further underline that sovereign bond return predictability is stronger during crisis periods and more pronounced for bonds of lower credit ratings. University College Dublin

If price volatility is caused in some part by taste shocks, then it should be positively correlated with the liquidity premium. Our argument is based on Krishna and Sadowski (2014), who provide foundations for a representation of dynamic choice with taste shocks, and show that volatility in tastes corresponds to a desire to maintain flexibility. To formally connect volatile tastes to price volatility and preference for flexibility to the liquidity premium, we analyze a modified simple Lucas tree economy with two otherwise identical assets, where one provides more liquidity because its output can be traded on an auxiliary international market, and where the representative agent is uncertain about his degree of future risk aversion. We show that a representative agent with a higher degree of uncertainty about his future risk aversion implies a higher liquidity premium (ie, a higher price for the more liquid asset) and more price volatility.

This paper analyses the intraday liquidity management game played in large-value payment systems accounting for a variable and a fixed cost of liquidity. While the liquidity cost is a decisive factor for settlement behaviour, the availability of intraday liquidity until end-of-day matters too, as it mutes late settlement incentives originating from settlement risk. Whether liquidity is provided via overdraft or intraday credit hardly matters. A late settlement fee can both disincentivise settlement coordination or implement early settlement. Its calibration is usually non-trivial with the major exception of a fixed cost and end-of-day availability of intraday liquidity.

We show foreign strategic investors provide monitoring protection, by reducing tunneling through intercorporate loans. Further, foreign strategic investors mitigate minority shareholders expropriation through controlling excessive borrowing, whereas firms without foreign-founders channel excessive borrowing to controlling shareholders using intercorporate loans. The monitoring benefits are greater when corporate governance is weaker, and when foreign strategic investors are from English common law countries. Compared to foreign investor proxies typically used in Chinese studies, we use foreign-founder shareholders. As foreign-founders are long-term investors facing high liquidity risk, they are highly motivated to actively monitor and influence firm behaviours.

There is increasing recognition that the effects of monetary policy are not symmetric across different sectors in the economy. For example, in recent empirical work, Givens and Reed (2018) focus exclusively on the capital goods sector and find that the impact of monetary policy on residential investment is more than twice as high as the behavior of fixed investment at the aggregate level. Why are the effects of monetary policy on residential investment so impactful compared to the overall capital sector? Further, what role do financial intermediaries play in promoting housing which is a significant component of personal wealth in the United States? To address the importance of housing for wealth accumulation, we study a model in which housing is traded across generations of individuals. Following Diamond and Dybvig (1983), individuals face stochastic liquidity preference shocks which impede housing accumulation. Intermediaries arise to help insure individuals against such idiosyncratic risk. However, inflation also limits the extent of risk-sharing. In this manner, the model follows recent contributions which emphasize that shocks to discount rates contribute to wealth inequality. Moreover, in contrast to one-sector monetary growth models, we demonstrate that it is important to disaggregate fixed investment between the residential and non-residential sectors to determine the effects of money growth. In particular, monetary policy will have asymmetric effects across the components of the overall capital stock.

This paper investigates from a theoretical and empirical perspective the effects of capital controls on cost-based measures of foreign exchange (FX) market liquidity. First, we propose a market microstructure model of the exchange rate where capital controls reduce the trades of constrained dealers. The effect is a tightening of the effective spread, which increases market liquidity. Then, we propose a new measure of capital account restrictiveness that, in contrast to other traditional measures, can account for intensive changes in capital controls policies. Using this measure in a panel of emerging market economies, we provide empirical evidence showing that capital controls can reduce the implicit cost component of FX market liquidity.

Motivated by liquidity risk in mathematical finance, Lacker (2015) introduced concentration inequalities for risk measures, i.e. upper bounds on the liquidity risk profile of a financial loss. We derive these inequalities in the case of time-consistent dynamic risk measures when the filtration is assumed to carry a Brownian motion. The theory of backward stochastic differential equations (BSDEs) and their dual formulation plays a crucial role in our analysis. Natural by-products of concentration of risk measures are a description of the tail behavior of the financial loss and transport-type inequalities in terms of the generator of the BSDE, which in the present case can grow arbitrarily fast.

This paper studies the welfare properties of mutual funds in a Diamond–Dybvig economy with two sources of aggregate risk: (i) shocks to long-term investment returns; and (ii) shocks to aggregate liquidity demand. Mutual funds are inefficient when the long-term investment is risky. Mutual funds improve upon autarky by introducing a wedge between the market and technological rates of return. However, the wedge distorts the decisions of consumers not facing liquidity shocks, and the resulting equilibrium is inefficient. If only aggregate liquidity demand is subject to shocks, mutual funds can implement the social optimum (even when liquidity demand is not directly observable) by means of a price-contingent dividend policy.

We analyse the behaviour of returns of various zero-investment (ZI) strategies motivated by the well-reported return crashes witnessed for momentum anomaly in down market states (DMS). We find that momentum crashes during market downturns are not unique. Instead, our results show that an alternating return generating process is at work across ZI strategies: almost half of ZI strategies exhibit momentum-like tendencies while the remainder displays an opposite pattern. In sum, this design is linked to the sign of systematic liquidity beta and the strength of falls/rises depend on the illiquidity gaps between the long and short portfolios of studied ZIS.

We investigate the cross-sectional determinants of corporate bond returns and find that downside risk is the strongest predictor of future bond returns. We also introduce common risk factors based on the prevalent risk characteristics of corporate bonds—downside risk, credit risk, and liquidity risk—and find that these novel bond factors have economically and statistically significant risk premiums that cannot be explained by long-established stock and bond market factors. We show that the newly proposed risk factors outperform all other models considered in the literature in explaining the returns of the industry- and size/maturity-sorted portfolios of corporate bonds.

The aim of this study is Islamic and conventional banking continued its activities in Turkey, the factors that affect liquidity risk management is to test the panel data regression analysis. For this purpose, quarterly financial data of Islamic and conventional banks were used. In the scope of the analysis, a total of 6 banks (3 participation and 3 traditional) operating between 2014-2018 were included. As a result of the analysis, it was found that there is a negative and statistically significant relationship between liquid assets (LA), gross domestic product (GDP) and inflation (INF) variables and liquidity risk at 99% confidence level for Islamic banks. NPL has a positive and statistically significant effect on Islamic banking with 95% reliability. The relationship between NPL and liquid assets (LA) variables and liquidity risk in conventional banks was negative and statistically significant at 95% and 99% confidence levels, respectively. These results are valuable in terms of which variables both conventional and Islamic banks should prioritize in managing liquidity risk.

Classical option pricing theories are usually built on the paradigm of competitive and frictionless markets, while ignoring the impact of market liquidity on underlying asset prices. In this paper, the importance of liquidity risk on discrete barrier option pricing is analyzed. First, we propose a new model for describing the asset price dynamics in the presence of jumps and liquidity risks, which is able to capture empirically observed patterns. Based on the COS method, we then derive the analytical approximation formulas for the prices of the discrete barrier options. Numerical experiments demonstrate the accuracy of our proposed pricing model by comparing the analytical approximation solutions with Monte Carlo simulation. Finally, empirically studies are carried out to show the superiority of our model based on SSE 50 ETF options. The numerical and empirical results support our idea of introducing liquidity risk and jumps into the underlying asset price dynamics.

Since the security market is too complex, there are situations where the future security returns cannot be reflected by historical data and have to be given by experts’ estimations according to their knowledge and judgements. This paper discusses a portfolio selection problem in such an uncertain environment. In the paper, in order to reflect different attitudes towards risk that vary by goal in one portfolio investment, we apply mental accounts to the investment. Uncertain variables are introduced to describe the securities’ return, and a new uncertain portfolio selection model is developed when return risk control and liquidity risk control are considered. In addition, other important limitations, i.e., transaction cost, minimum transaction lot, bounds of holding, security diversification and sector diversification are also considered. In real life, investors face background risk which may affect their portfolio selection decisions. Thus, background risk is also considered. To solve the proposed problem, the equivalents of the model are proposed. Finally, a numerical example is given as an illustration.

Corporate bond mutual funds increased their selling of credit protection in the credit default swaps (CDS) market during the 2007–2008 financial crisis. This trading activity was primarily in multi-name CDS, greater among larger and established funds, and directed toward counterparty dealers in financial distress. Funds that sold credit protection during the crisis experienced greater credit market risk and superior post-crisis performance, consistent with higher expected returns from liquidity provision. Funds using Lehman Brothers as a counterparty experienced abnormal outflows and returns of –2% immediately following Lehman's bankruptcy, suggesting that funds’ opportunistic trading in CDS exposed investors to counterparty risk.

This paper discusses a multi-period and tri-objective portfolio optimization problem, where asset returns are formalized as uncertain variables. Based on uncertainty theory, a multi-period and tri-objective uncertain portfolio model is proposed, which considers the loss-averse utility, liquidity risk and diversification degree simultaneously. Additionally, a chance constraint is introduced into the model to reflect investors’ safety requirement during the investment period. To solve the portfolio model, a self-adaptive particle swarm optimization (SAPSO) is also proposed. In SAPSO, a self-adaptive stochastic ranking approach is employed to balance the abilities of exploration and exploitation in the searching process. Finally, a numerical experiment is presented. The results show that SAPSO is effective to solve the proposed model and the proposed portfolio model can express investors’ preference by adjusting the objective weights.

We study sovereign debt and default policies when credit and liquidity risk are jointly determined. To account for both types of risks we focus on an economy with incomplete markets, limited commitment, and search frictions in the secondary market for sovereign bonds. We quantify the effect of liquidity on sovereign spreads and welfare by performing quantitative exercises when our model is calibrated to match key features of the Argentinean default in 2001. From a positive point of view, we find (a) that a substantial portion of sovereign spreads is due to a liquidity premium, and (b) the liquidity premium helps to resolve the "credit spread puzzle," by generating high mean spreads while maintaining a low default frequency. From a normative point of view, we find that reductions in secondary market frictions improve welfare.

Traditional exposure measures focus on direct exposures to evaluate the losses an institution is exposed to upon the default of a counterparty. Since the Global Financial Crisis of '07/'08, indirect exposures via common asset holdings are increasingly recognized too. Yet direct and indirect exposures fail to capture the losses that result from shock propagation and amplification following the counterparty's default. In this paper, we introduce the concept "higher-order exposures" to refer to these spill-over losses and propose a way to formalize and quantify them. Using granular data of the South African financial system, we show that higher-order exposures make up a significant part of exposures – particularly during times of financial distress when exposures matter most. We also show that higher-order exposures cannot simply be extrapolated from direct or indirect exposures, since they depend strongly on the network structure and the robustness of individual institutions. Our findings suggest that higher-order exposures should inform the design and calibration of those tools in the regulators' arsenal where exposures matter -- including large exposure limits, capital requirement calibration, stress test design and resolution. Failure to do so may result in both lax ex-ante regulation and ill-informed ex-post handling of financial crises.

I study the active liquidity management of equity mutual funds in the U.S. First, I show that mutual funds actively increase the liquidity of their portfolios in response to a negative and exogenous shock to investor flows. I document that fund managers use both equity and cash holdings to adjust their portfolio liquidity when subject to sudden and unexpected withdrawals. Second, I argue that active liquidity management is an effective device that skilled managers use to minimize the cost imposed by redemption obligations. I find that funds that actively manage their liquidity to a greater degree significantly outperform their less liquidity-focused peers.

The current position of the business can be verified through ratios analysis. According to this analysis managers, creditors, and investors can receive valuable information about the effectiveness and efficiency of the operations. Managers by using especially profitability, operating, and asset utilization ratios can maintain a fairly accurate perception of the financial health of their business. Different types of ratios can help them as they are indicator of well goals are being achieved. When actual results can not meet the standard set, then, ratios indicate where the problem may be. There are different types of ratios. Liquidity ratios are current and quick asset ratios. Profitability and operating ratios are return on asset, gross profit margin and net profit margin. Gearing ratios are divided into debt to equity ratio and number of times interest earned. There are different shareholder investment ratios such as return on shareholders, earnings per share, price earnings ratio, dividend yield and dividend covers. Under asset utilization ratios, we have the net asset turnover, debtor collection period, stockholding period and creditor payment period. Investment appraisal is a process which assists mangers to take decisions and evaluate the future success of a project in terms of profitability, suitability, and compatibility with company objectives. The value of money changes with time. Money received today has a different value from money received in the future. the investors before making any investment must take into consideration that different types of securities will have different kinds of risks. The several sources of risk can be classified as: interest rate risk, market risk, inflation risk, business risk, exchange rate risk, financial risk, country risk, and liquidity risk. No investment will be made unless the expected rate of return is high enough to compensate the investor for taking extra risks. In general, it is believed that the higher the perceived risk associated with an investment opportunity, the higher should be its expected return to persuade an investor to accept the investment opportunity. Investors are risk averse, namely that they want to reduce their risk through a diversified balanced portfolio. This leads us to modern portfolio theory, which was developed by Markowitz (1959). Arbitrage pricing theory, APT, is a more general approach to asset pricing because it allows for the possibility that many factors can be used to explain security returns. The assets of a company are financed by either debt or equity. After calculating the cost of capital for equity and debt, then, we combine them in a form of weighted average to calculate the final weighted average cost of capital. The reason of measuring the weighted average cost of capital is to find how much interest the company or the government has to pay for every Euro it borrows. Factors that affect the cost of capital are the capital structure of the company, the dividend policy, the investment policy, the level of interest rates and the tax rates. Managing the working capital of the business is very important step that will prevent the shareholders from bankruptcy. It is very important to control short and long – term cash in relation to short and long – term liabilities. The relationship between fixed and variable costs is very important to determine the amount of leverage that the company will use. Leverage is determined by the profit changes due to changes in sales. The proportion of costs in the capital structure of a company determines the level of leverage that the company will use. The valuation of a derivative product is determined by changes of the main asset. They are risky products and due to the leverage effect they provide high positive or negative returns. Business valuation is an important measure in case that the shareholders seek short- term liquidity to finance their debt. The most common measures are dividend yield, price earnings ratio and net asset value.

This paper proposes a reengineered and robust approach to optimal economic capital allocation, in a Liquidity-Adjusted Value at Risk (LVaR) framework, and particularly from the perspective of trading portfolios that have both long and short trading positions and disallowing both long-only positions and borrowing constraints. This paper expands previous approaches by explicitly modeling the liquidation of trading portfolios with the aid of an appropriate scaling of the multiple assets’ LVaR matrix along with GARCH-M technique to forecast conditional volatility and expected return.

Illiquidity measures appear to be related to monthly realized returns but do they actually impact the long-run costs of capital for firms? We make progress on this issue by analyzing the relation between the well-known Amihud (2002) liquidity measure and actual cost-of-capital (CoC) estimates, which rely on imputing the internal rate of returns on firms’ equity cash flows. Using U.S. data, after controlling for well-known determinants of CoC, we find that illiquidity is strongly and negatively related to CoC estimates. This result obtains even as we confirm that illiquidity is positively related to monthly realized returns. Liquidity risk and the probability of informed trading bear no relation to CoC. While our results do not rule out that short horizon investors demand compensation for illiquidity, our results run contrary to the notion that corporations should care about illiquidity, liquidity risk, or information risk, while setting discount rates for long-term projects.

The recent growth in financial assets trading in emerging markets indicates that more attention is required for the measurement, management and control of risks. In this research study, I discuss the methodological aspects for the assessment of liquidity risk and provide an intuitive approach for its applications to modern risk management processes in financial institutions.

This article presents an update of the analysis of French-domiciled funds’ prospectuses carried out jointly by the Autorite des marches financiers and the Banque de France (Darpeix, LeMoign, Meme, Novakovic, 2020). The first contribution of this new study is to bring a time dimension to the study of the deployment of liquidity management tools in investment funds since the implementation of the recommendations of the Financial Stability Board (2017) and of the International Organization of Securities Commissions (2018). These tools, introduced into the French regulatory framework, are a response to the financial stability issues that have been identified concerning liquidity in investment funds around the world. The second contribution of this article is to allow for a granular assessment of LMTs’ uptake, by fund type and according to various fund characteristics (funds serving as units for unit-linked insurance products, employee savings funds, ETFs, regulatory nature - UCITS or AIFs-) via merges with other databases. The main result from this article is that even if a progression of the deployment is indeed observed in certain categories of funds, there is still to this day a significant margin of improvement for the liquidity management tools to become a market standard for French investment funds

We examine changes in systemic liquidity risk brought about by the trade-through prohibition and the fragmentation of order flow caused by Reg NMS. A dynamic factor model allows us to decompose liquidity co-variances into “exchange-specific” and “market-wide” components. We document a decrease in liquidity measures driven by exchange-specific factors, and an increase in the variance explained by market-wide factors following the implementation of Reg NMS. Overall commonality decreases, with liquidity shocks smoothed across multiple trading venues. While liquidity shocks are shared among more exchanges (becoming more systemic), the impact of a single shock on any individual exchange actually declines.

We analyze the impact of a requirement similar to the Basel III Liquidity Coverage Ratio (LCR) on conventional monetary policy implementation. Combining unique data sets of Dutch banks from 2002 to 2005, we find that the introduction of the LCR impacts banks’ behaviour in open market operations. After the introduction of the LCR, banks bid for higher volumes and pay higher interest rates for central bank funds. In line with theory, banks reduce their reliance on overnight and short term unsecured funding. We do not observe a worsening of collateral quality pledged in open market operations. Thus, to correctly anticipate an open market operation’s effect on interest rates, monetary policy requires central banks to consider not only the size of the operation, but also how it impacts banks’ liquidity management and compliance with the LCR.