Market Liquidity and Funding Liquidity

Markus K. Brunnermeier

Princeton University

Lasse Heje Pedersen

New York University

The Review of Financial Studies, Vol. 22, No. 6, 2009

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Margin requirement for CME members as a fraction of the S&P500 index level

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Motivation

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Earlier Studies

Research Dimension Author/Authors Major Finding

Margin Spiral Adrian and Shin (2009),Vayanos (2004)

The margin spiral forces traders to de-lever duringdownturns.

Loss Spiral Mitchell, Pedersen, and Pulvino (2007),Morris-Shin (2004), Shleifer-Vishny (1997), Grossman & Miller (1988)

liquidity-driven divergence of prices from fundamentals

Commonality of liquidity across assets

Chordia et al (2000), Hasbrouck & Seppi (2001), Huberman and Halka (2001)

market liquidity is correlated across stocks

Market liquidity vs volatility

Benston & Hagerman (1974) ,Amihud & Mendelson (1989)

market liquidity declines as fundamental volatility increases.

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Theoretical Framework Examines Market Liquidity

1. can suddenly dry up,

2. has commonality across securities,

3. is related to volatility,

4. is subject to “ flight to quality,” and

5. co-moves with the market.

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Liquidity Spiral

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Margin spiral: when the margin requirement for liquidity provider (speculators) increases due to market illiquidity. Loss spiral: when speculators hold a large initial position that is opposite to customers’ market demand.

Customers’ Demand Shock Financier margin

update

Conclusion

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New Testable Predictions

1. Determinant of Margin requirement-

1. fundamental volatility (long term price change) and

2. liquidity-driven volatility (short term – long term price change)

2. Commonality in liquidity- speculators’ shadow cost of capital (movement of market liquidity)

3. Existence of margin spiral and liquidity spirals

4. Empirical test of Liquidity spiral in market downturn

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Thanks

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Framework Terms

Market liquidity=

Funding liquidity= speculators’ fund scarcity

Three time period model t = 0,1,2,3 Market participants= customers, speculators and financiers Financier = informed or uninformed Volatility= fundamental or liquidity shock Small shock loss spiral margin spiral Loss spiral…… Big Liquidity Shock

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Liquidity Spiral