Liquidity Risk and the Structure of Financial Crises
Lasse Heje PedersenNYU, CEPR, NBER
October, 2008
Prepared for theInternal Monetary Fund
and Federal Reserve Board
See also my related blog: http://sternfinance.blogspot.com
Page 1
A Report from an Academic Returning from the Trenches
Page 2
Overview of Talk
Theory• What is liquidity risk?• How should liquidity risk affect prices and returns?• What happens during liquidity crisis?
Evidence from notable liquidity crisis:• The current crisis• 2007 quant equity • 2005 convertible bond market • 1998 LTCM • 1987 stock market crash
Conclusion• Will it happen again? • How do we solve the crisis and reduce the risk of future ones?• Liquidity risk lessons
Page 3
What is Liquidity Risk
Market liquidity: • A security is considered liquid if it is “easy” to trade: Low bid-ask spread,
small price impact, high resilience, easy search (in OTC markets)
Market liquidity risk:• The risk that the market liquidity worsens when you need to unwind
Funding liquidity:• A trader’s available funding from own capital and (collateralized) loans
Funding liquidity risk: • The risk that a trader cannot fund his position and is forced to unwind
Page 4
The Pricing of Market Liquidity Risk: Introducing Liquidity Betas
Investors care about returns net of trading costs• They want to be compensated for illiquidity and liquidity risk• CAPM holds for net returns in an OLG model.
Decomposing systematic risk of return net of trading costs:
total systematic risk component sign interpretation
Cov(Ri – Ci, RM – CM) = Cov(Ri , RM) + standard market beta + Cov(Ci , CM) + commonality in liquidity– Cov(Ri , CM) – return exposure to market liquidity– Cov(Ci , RM) – liquidity exposure to market risk
Three liquidity betas, after division by Var(RM– CM)
Page 5
The Pricing of Market Liquidity Risk: Liquidity-Adjusted CAPM
Liquidity-adjusted CAPM:
Et(rt+1) = rf + Et (ct+1) + λt ( βtM + βt
L1 - βtL2 - βt
L3 )
Empirical tests consistent with predictions: explanatory power in the cross-section, positive risk premium, expected signs of betas.
An increase in illiquidity increases the required return:
and contemporaneous returns are low.
Source: Acharya and Pedersen (Journal of Financial Economics, 2005)
( )( )
( )( )
( )( ) ( )fM
tM
ttMt
Mtt
Mt
ittL
tMt
Mtt
Mt
ittL
tMt
Mtt
Mt
ittL
t rcrEcrrc
crcr
crcc
−−=−
=−
=−
= ++++
++
++
++
++
++11
11
113
11
112
11
111
var,cov
var,cov
var,cov λβββ
( ) 01 >−∂∂
+f
ttt
rrEC
( ) 0,cov <ttt rc
Real World Examples
• Securities with high liquidity risk: high average return empirically
• Lesson from LTCM: liquidity important risk factor
• Current crisis:Ct is increasedλt is increasedLiquidity risk increased
→ Prices are down
Page 6
What Drives Market Liquidity Risk
Liquidity is provided by market makers, hedge funds, prop. traders, “speculators”
Speculators must be able to fund their positions, both long positions x+ and short ones x- :
If speculators are well funded (large capital W and/or low margins m), then• they can trade more (larger x+ and x- )
→ which enhances market liquidity• “Funding liquidity” is a driver of market liquidity
There is also feedback in the opposite direction:• Better market liquidity can lower margins because
financiers more willing to lend when they can more easily and quickly sell the collateralmarket liquidity can lower volatility
→ eases funding restriction
This mutual feedback can give rise to liquidity spirals
Page 7
Liquidity Spirals
Sources: Garleanu and Pedersen (2007) and Brunnermeier and Pedersen (2008)
Some traders hit or near margin constraints (or risk limits) and reduce positions, which• moves prices against them (and others with similar positions) leading to further losses• increases volatility and reduces market liquidity, leading to increased margins and
tightened risk management (including reduction in counterparty exposure)
These effects continue until a new equilibrium is reached• loss-spiral• margin-spiral• risk-management-spiral
funding problems
reduced positions
higher margins
prices move away from fundamentals
initial losses e.g. due to credit
losses on existing positions
tighter risk management
Page 8
Speculators consider each security j to maximize expected profit per capital use • So, in equilibrium, profit-per-capital-use must be equal for all securities • The common profit per capital use is the shadow cost of capital, denoted φ
profitj / capital-usej = φ (I)
Note that: Cj = market illiquidityj = trading cost of liquidity-demanderj = profit of speculatorsj (II)mj = marginj = capital-use of securityj (III)
Combining (I), (II), and (III) yields
Cj / mj = φ =>
Cj = mj * φ
I.e. equilibrium a security’s market liquidity is the product of• its capital use i.e. margin
which depends on its risk, trading characteristics• the general scarcity of speculator capital, i.e. funding liquidity
See Brunnermeier and Pedersen (2007) for a formal theory.
Market Liquidity Risk Across Securities: Commonality and Differences
Real World Example:
Currently funding liquidity is low,i.e. bank balance sheet is scarce
Hence, market liquidity is low,especially for high margin securitieslike convertible bonds
Page 9
Market Liquidity and Funding Liquidity: Explaining the Stylized Facts
Sudden liquidity “dry-ups”• liquidity spirals for market and funding liquidity• destabilizing margins, risk controls, redemptions
Commonality of liquidity:• these funding problems affect many securities
Market liquidity correlated with volatility:• volatile securities require more capital to finance
Flight to quality / flight to liquidity:• when capital is scarce, traders withdraw more from “capital intensive” high-margin
securities
Market liquidity moves with the market• because funding conditions do
See Brunnermeier and Pedersen (2007) for a formal theory.
Page 10
Commonality of Liquidity and Flight to Quality: Example
wealth shock to liquidity providers
pric
e of
ass
ets
1 an
d 2
asset 2 with high risk
asset 1 with low risk Jump leading tosudden liquiditydry up
Page 11
Funding Liquidity Leads to Conditional Skewness and Kurtosis
• Price moves associated with losses for liquidity providers: amplified by liquidity spirals• Price moves associated with gains: not amplified
Real World Example:
FX carry trade unwind
“investment currencies go up by the stairsand down by the elevator”
Source: Brunnermeier, Nagel, and Pedersen (2008)
Source: Brunnermeier and Pedersen (2008)
Page 12
Examples of Liquidity Events
Page 13
Examples of Liquidity Events
What happens in the real world liquidity crisis:
• Current crisis• 2007 August quant equity• 2005 Convertible bonds• 1998 LTCM and convertible bonds• 1987 Stock market crash and merger arbitrage
Page 14
The Current Crisis
Housing bubble and burst
Large losses in the levered financial sector
Liquidity spirals as• banks’ balance sheets deteriorate • banks de-lever, selling assets• risk management tighten, lending reduced, counterparty exposures minimized• margins increase• liquidity vanishes• prices drop
Extreme liquidity risk• Extreme funding liquidity risk: your bank may default• Extreme market liquidity risk: dealers shutting down (no bids!)
Page 15
The Trigger: Housing Bubble and Bust
Case-Shiller CSXR
0.00
50.00
100.00
150.00
200.00
250.00Ja
n-87
Jan-
88
Jan-
89
Jan-
90
Jan-
91
Jan-
92
Jan-
93
Jan-
94
Jan-
95
Jan-
96
Jan-
97
Jan-
98
Jan-
99
Jan-
00
Jan-
01
Jan-
02
Jan-
03
Jan-
04
Jan-
05
Jan-
06
Jan-
07
Jan-
08
Page 16
Housing Bust hits Mortgage-Based Credit Markets and Beyond
0
100
200
300
400
500
600
7001/
19/2
006
3/19
/200
6
5/19
/200
6
7/19
/200
6
9/19
/200
6
11/1
9/20
06
1/19
/200
7
3/19
/200
7
5/19
/200
7
7/19
/200
7
9/19
/200
7
11/1
9/20
07
1/19
/200
8
3/19
/200
8
5/19
/200
8
7/19
/200
8
9/19
/200
8
ABX AAA (2006-1)CMBX NA.1 AAAIG
Page 17
This Creates Losses and Funding Liquidity Problems for Banks
5Y CDS Spreads
0%
2%
4%
6%
8%
10%
12%
14%
16%
10/6
/06
11/6
/06
12/6
/06
1/6/
07
2/6/
07
3/6/
07
4/6/
07
5/6/
07
6/6/
07
7/6/
07
8/6/
07
9/6/
07
10/6
/07
11/6
/07
12/6
/07
1/6/
08
2/6/
08
3/6/
08
4/6/
08
5/6/
08
6/6/
08
7/6/
08
8/6/
08
9/6/
08
10/6
/08
BearGSJPMLehmanMLMS
Page 18
Banks Tighten Risk Management and Reduce Inter-bank Lending: Funding Spreads Rise
TED Spreads
-1.000
0.000
1.000
2.000
3.000
4.000
5.0001/
1/19
97
7/1/
1997
1/1/
1998
7/1/
1998
1/1/
1999
7/1/
1999
1/1/
2000
7/1/
2000
1/1/
2001
7/1/
2001
1/1/
2002
7/1/
2002
1/1/
2003
7/1/
2003
1/1/
2004
7/1/
2004
1/1/
2005
7/1/
2005
1/1/
2006
7/1/
2006
1/1/
2007
7/1/
2007
1/1/
2008
7/1/
2008
BD CN JP UK US
Page 19
Funding Liquidity Problems for Everyone: Banks Unwillingness to Lend
% Increasing Spreads of Loan Rates over Banks' Cost of Funds (source: FRB)
-80
-60
-40
-20
0
20
40
60
80
100
1990
:0219
91:01
1991
:0419
92:03
1993
:0219
94:01
1994
:0419
95:03
1996
:0219
97:01
1997
:0419
98:03
1999
:0220
00:01
2000
:0420
01:03
2002
:0220
03:01
2003
:0420
04:03
2005
:0220
06:01
2006
:0420
07:03
2008
:02
Page 20
Further Funding Problems: Volatility Spikes, increasing Margins
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
1/3/
90
1/3/
91
1/3/
92
1/3/
93
1/3/
94
1/3/
95
1/3/
96
1/3/
97
1/3/
98
1/3/
99
1/3/
00
1/3/
01
1/3/
02
1/3/
03
1/3/
04
1/3/
05
1/3/
06
1/3/
07
1/3/
08
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
1/1/
07
2/1/
07
3/1/
07
4/1/
07
5/1/
07
6/1/
07
7/1/
07
8/1/
07
9/1/
07
10/1
/07
11/1
/07
12/1
/07
1/1/
08
2/1/
08
3/1/
08
4/1/
08
5/1/
08
6/1/
08
7/1/
08
8/1/
08
9/1/
08
10/1
/08
VIX Realized Volatility
Page 21
Further Funding Problems: Commercial Paper Market
Outstandings
Rates
Source: Federal Reserve Bank
Page 22
Market Liquidity Deteriorates: Bid-Ask Spreads
Percentage Bid-Ask Spread
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
10/1
0/20
07
10/2
4/20
07
11/7
/200
7
11/2
1/20
07
12/5
/200
7
12/1
9/20
07
1/2/
2008
1/16
/200
8
1/30
/200
8
2/13
/200
8
2/27
/200
8
3/12
/200
8
3/26
/200
8
4/9/
2008
4/23
/200
8
5/7/
2008
5/21
/200
8
6/4/
2008
6/18
/200
8
7/2/
2008
7/16
/200
8
7/30
/200
8
8/13
/200
8
8/27
/200
8
9/10
/200
8
9/24
/200
8
10/8
/200
8
0.0%
0.1%
0.1%
0.2%
0.2%
0.3%
0.3%
0.4%
0.4%
0.5%
0.5%
ABX-HE-AAA 06-1 ABX-HE-AAA 06-2 ABX-HE-AAA 07-1 HY (right axis)
Page 23
Extreme Liquidity Crisis: Covered Interest Rate Parity Fails
Deviation of Covered Interest-Rate Parity vs. USD
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
21/
1/20
05
3/1/
2005
5/1/
2005
7/1/
2005
9/1/
2005
11/1
/200
5
1/1/
2006
3/1/
2006
5/1/
2006
7/1/
2006
9/1/
2006
11/1
/200
6
1/1/
2007
3/1/
2007
5/1/
2007
7/1/
2007
9/1/
2007
11/1
/200
7
1/1/
2008
3/1/
2008
5/1/
2008
7/1/
2008
9/1/
2008
Perc
enta
ge P
oint
s (a
nnua
lized
)
AU BD CN JP NW NZ SD SW UK
Page 24
Prices Drop, Especially of Illiquid Assets: Losses by Hedge Funds
CS Tremont HF Index
-0.25
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
0.2
0.25
0.3
Jun-07
Jul-07
Aug-07
Sep-07
Oct-07
Nov-07
Dec-07
Jan-08
Feb-08
Mar-08
Apr-08
May-08
Jun-08
Jul-08
Aug-08
Sep-08
Convertible Arbitrage Dedicated Short Bias Emerging Markets Equity Market Neutral Event Driven Distressed Multi-Strategy Risk Arbitrage Fixed Income Arbitrage Global Macro Long/Short Equity Managed Futures Multi-Strategy
Page 25
Correlations Increase: Everything Trades on Liquidity
Commonality among SP500, Bonds, Crude, $-Yen, Gold:Percent of Correlation Explained by First Principle Component
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
1/1/
07
2/1/
07
3/1/
07
4/1/
07
5/1/
07
6/1/
07
7/1/
07
8/1/
07
9/1/
07
10/1
/07
11/1
/07
12/1
/07
1/1/
08
2/1/
08
3/1/
08
4/1/
08
5/1/
08
6/1/
08
7/1/
08
8/1/
08
9/1/
08
10/1
/08
Correlation between Value and Momentum
-1.20-1.00-0.80-0.60-0.40-0.200.000.200.400.600.801.00
7/26
/07
8/9/
07
8/23
/07
9/6/
07
9/20
/07
10/4
/07
10/1
8/07
11/1
/07
11/1
5/07
11/2
9/07
12/1
3/07
12/2
7/07
1/10
/08
1/24
/08
2/7/
08
2/21
/08
3/6/
08
3/20
/08
4/3/
08
4/17
/08
5/1/
08
5/15
/08
5/29
/08
6/12
/08
6/26
/08
7/10
/08
7/24
/08
8/7/
08
8/21
/08
9/4/
08
9/18
/08
Page 26
All These Liquidity Effects are Connected in Equilibrium
-2.00
-1.00
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
1/1/
2007
2/1/
2007
3/1/
2007
4/1/
2007
5/1/
2007
6/1/
2007
7/1/
2007
8/1/
2007
9/1/
2007
10/1
/200
7
11/1
/200
7
12/1
/200
7
1/1/
2008
2/1/
2008
3/1/
2008
4/1/
2008
5/1/
2008
6/1/
2008
7/1/
2008
8/1/
2008
9/1/
2008
10/1
/200
8
VIX/10 CIP deviation US TED ABX AAA06 ABX Bid-Ask short SP500
Page 27
August 2007 Quant Equity Event Background: What is a Quant Hedge Fund
Traditional non-quant hedge funds: “discretionary trading”:• Buy/sell based on an analyst’s overall assessment of certain selected
securities
Quantitative method:• Define trading rules explicitly• Back test using historical data• Build a system that implements trading idea systematically • Using economics, novel data, and novel data processing to identify
relationships market participants may missFinding subtle relationships that the market does not easily understandSuperior processing of ideas using a wealth of data that cannot be easily processed using non-quantitative methods
Page 28
Chronology of the 2007 Quant Event
July 2007:• Credit spreads started to widen after sub-prime mortgage turmoil• Losses in certain multi-strategy hedge funds, who started reducing risk and raise cash
by selling liquid instruments• Money pulled out of potential LBO candidates with strong value and cash flow
characteristics, hurting the value strategy• Fund-of-fund hit loss triggers and redeem from certain hedge funds• Value stocks behave poorly with unusual correlation structure
August 2007• Major de-levering of quant strategies• Spill-over
from value to other quant factorsfrom the US to international markets
• Since the large price movements were created by de-leveraging, prices bounced back
Page 29
Estimated Reduction of Overall Quant Positions
$300-$400 billion oflong exposures $175-$250 billion of
long exposures
$300-$400 billion ofshort exposures
$175-$250 billion ofshort exposures
Pre Sell-Off Post Sell-Off
Page 30
Spillover from US to other Markets
Valuation Factor Returns, July 1 – August 24
-35.00%
-30.00%
-25.00%
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
7/1-
7/25
27-J
ul
31-J
ul
2-A
ug
6-A
ug
8-A
ug
10-A
ug
14-A
ug
16-A
ug
20-A
ug
22-A
ug
24-A
ug
US Valuation JP Valuation Aus Valuation
Page 31
-20.00%
-18.00%
-16.00%
-14.00%
-12.00%
-10.00%
-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
2007080609:31:00
2007080709:31:00
2007080809:31:00
2007080909:31:00
2007081009:31:00
2007081309:31:00
2007081409:31:00
Minute-by-Minute Cumulative Return to Value Factor, August 6 - 14
7 % annualized vol ~ 7% / Sqrt(252) = 44 bps daily vol (vol. estimates from BARRA)
Move largest for illiquid stocks
Mon Tue Wed Thu Fri Mon Tue
Page 32
Evidence of Liquidity Event due to Unwinding
Mon Tue Wed Thu Fri Mon Tue
Return -1.34% -4.52% -6.20% -4.23% 9.82% 2.20% 0.35%
# Stds (1 std is 0.44%) -3 -10 -14 -10 22 5 1
P-value "normal" day 0.23% 0.00% 0.00% 0.00% 0.00% 0.00% 42%
Positive returns (%) 31% 10% 32% 41% 75% 43% 56%
Negative returns (%) 69% 90% 68% 59% 25% 57% 44%
Positive returns (%) 42% 32% 35% 42% 67% 47% 52%
Negative returns (%) 58% 68% 65% 58% 33% 53% 48%
P-value random walk 0.10% 0.00% 0.00% 0.10% 0.00% 24% 39%
1 minute intervals
10 minute intervals
Page 33
Interpretation
Liquidity events can happen even in the most liquid markets in the world
Market and funding liquidity are related
Liquidity shocks are• sudden• common and spill over• affect mostly risky and illiquid securities
Everyone seeks the highest alpha portfolio• The best quants are likely to be correlated• One needs to stay one step ahead
Prices drop more and rebound slower in more illiquid markets • Cf. Duffie, Garleanu, Pedersen (Review of Financial Studies, 2007)
Page 34
2005 Convertible Bond Event
Capital outflow due to redemptions from convertible bond hedge funds
Single-strategy hedge funds: • forced sellers of convertible bonds
Multi-strategy hedge funds• had a choice: what do you think that they did?
What happens to the price of convertible bonds?
Page 35
Background: What is a Convertible Bond
Convertible bond: • Corporate bond + call option (+ more)
Theoretical value can be inferred from• Issuer stock price• Stock price volatility• Option-implied volatility• Risk-free interest rates• Credit spreads • Just like the price of a “Gin and Tonic” can be inferred from the respective
prices of gin and tonic, and the amounts of each needed
Page 36
Convertible Bond Arbitrage
Buy convertible bond if it trades at a discount
Short the issuer’s stock
Potentially:• Short risk-free bonds• Short non-convertible bonds (or buy CDS)• Short stock options
Page 37
Convertible Bond Arbitrage Capital Outflows in 2005
Natural liquidity providers: Convertible Bond Arbitrage Hedge Funds (HFs)
Capital outflows in 2005:• 2005Q1: 20% capital redeemed• 2005Q1 – 2006Q1: assets fell by half
Convert Arb HFs sold convertible bonds
Page 38
Redemptions in 2005
0.0
10.0
20.0
30.0
40.0
50.0
60.0
70.0
2004-4 2005-1 2005-2 2005-3 2005-4 2006-1 2006-2 2006-3Date
So urce: B arclay Gro up
Con
vert
Arb
HF
Ass
ets
Und
er
Man
agem
ent (
$B)
Page 39
Redemptions Led to Selling: Adjusted Holdings of Convertible Bonds
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
40.0
45.0
2004
-1
2004
-2
2004
-3
2004
-4
2005
-1
2005
-2
2005
-3
2005
-4
2006
-1
2006
-2
2006
-3
Date
Adj
. Hol
ding
s of
Con
verti
ble
Bon
ds (B
illio
n $)
Convert Arb HFs
Multi-strategy HFs
Convert Mutual Funds
Source: Mitchell, Pedersen, and Pulvino (American Economic Review, 2007)
Page 40
Convertible Bond Arbitrage Returns and Market Price / Theoretical Value
0.96
0.98
1.00
1.02
2004
1220
0501
2005
0220
0503
2005
0420
0505
2005
0620
0507
2005
0820
0509
2005
1020
0511
2005
1220
0601
2006
0220
0603
2006
0420
0605
2006
0620
0607
2006
0820
0609
Date
Mar
ket P
rice
/ The
oret
ical
Val
ue
0.85
0.90
0.95
1.00
1.05
1.10
Cum
ulat
ive
Ret
urn
Market Price/Theoretical Value(left scale)
Cumulative Return(right scale)
Source: Mitchell, Pedersen, and Pulvino (American Economic Review, 2007)
Page 41
Interpretation
Prices drop and rebound
Price-to-fundamentals lowest around redemption notices (45 days before end of June and end of December)
Returns negative, then positive
Response by other traders:• Multi-strategy hedge funds• Mutual funds
Page 42
The Case of Amaranth
In 2005, Amaranth had• Losses in convertible bonds• Profits in energy trading• Overall profit and no capital problems
Decided to liquidate convertible bonds at time of significant cheapness
Collapsed in 2006 due to losses in energy
Page 43
LTCM Blowup in 1998: Implications for Convertible Bonds
Large hedge fund LTCM had losses due to Russian default, option positions, etc.
Had to liquidate large position in convertible bonds
What happened to the price of the bonds and how was the subsequent return?
Page 44
Convertible Bond Arbitrage Returns and Market Price / Theoretical Value
0.95
0.98
1.00
1.03
1997
1219
9801
1998
0219
9803
1998
0419
9805
1998
0619
9807
1998
0819
9809
1998
1019
9811
1998
1219
9901
1999
0219
9903
1999
0419
9905
1999
0619
9907
1999
0819
9909
1999
1019
9911
1999
12
Date
Mar
ket P
rice
/ T
heor
etic
al V
alue
0.80
0.85
0.90
0.95
1.00
1.05
1.10
1.15
1.20
1.25
Cum
ulat
ive
Ret
urn
Market Price/Theoretical Value(left scale)
Cumulative Return(right scale)
Source: Mitchell, Pedersen, and Pulvino (American Economic Review, 2007)
Page 45
1987 Crash: Implications for Merger Arbitrage
Oct. 14-16: U.S. House Ways and Means Committee proposed legislation
Oct. 19 (Black Monday) and 20: crash
Oct: 21-31: • Stock market rebounds• Congress backs off proposed legislation• But, merger-arbitrage proprietary traders
had lost a significant amount of capital Did they start buying or keep selling?What happed to merger spreads?
Berkshire Hathaway Annual Report (Warren Buffett):
“During 1988 we made unusually large profits from [risk] arbitrage … the trick, a la Peter Sellers in the movie, has simply been ‘Being There.’ ”
Page 46
Background on Merger Arbitrage
In a merger, “target” is bought at a premium, say 20-30%.At announcement, target price increases to a value close to the offer value. But, there remains a “deal spread,” typically around 3%
Due to• Risk of deal failure• Selling pressure: Mutual funds sell after announcement
Merger arbitrageurs buy target• Stock deal: hedge by shorting acquirer• Cash deal: no hedge
pricetarget price– target eoffer valu spread deal =
Page 47
Merger Arbitrage and the 1987 Crash
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
1987
1001
1987
1015
1987
1029
1987
1112
1987
1127
1987
1211
1987
1228
Date0.50
0.60
0.70
0.80
0.90
1.00
1.10
1.20
Cum
ulat
ive
Ret
urn
Median Deal Spread(left scale)
Prop Desk Net Purchases(left scale)
Cumulative Return(right scale)
Med
ian
Mer
ger A
rbitr
age
Dea
l Spr
ead,
and
Net
Pur
chas
es a
s %
of L
ong
Mar
ket V
alue
Source: Mitchell, Pedersen, and Pulvino (American Economic Review, 2007)
Page 48
Conclusions
Page 49
Conclusion: Will Liquidity Events Happen Again?
Yes, almost surely in some markets• Certain trades often get crowded over time• Sudden losses can lead to simultaneous unwind and liquidity spirals
Liquidity crisis is part of the equilibrium:• If there was no risk of crisis, traders will have an incentive to lever up more
Crises are (somewhat) rare• Banks try to stay liquid and traders actively try to stay away from margin
constraint• Most likely to occur in illiquid markets in which levered specialized traders
play a large role• Least likely in liquid market using unique strategies
Page 50
Conclusion: How do We Solve the Crisis and Reduce the Risk of Future Ones?
Recapitalize banks• Raise new capital, dilute old equity, possibly reduce face value of old debt• Quick resolution bankruptcy for institutions with systemic risk, i.e. causing liquidity
spirals
Improve funding markets and trust• Broaden bank guarantees, open discount window (collateralized funding with reasonable
margins), ensure CP market
Risk management• must acknowledge systemic risk due to liquidity spirals• Policy and regulations must consider system, as opposed to each institution in isolation
Page 51
How do We Solve the Crisis and Reduce the Risk of Future Ones, Continued
Trading with a clearing house preferable • allows netting out• reduce counterparty co-dependencies• increases transparency
Stock transaction taxes not a good idea:• moves trading away and into the land of OTC derivatives with no clearing house• reduces liquidity and, hence, increases firms’ cost of capital (liquidity-adjusted
CAPM)• importance of the ability to raise capital is what this crisis is all about
Shortselling ban is not a good idea:• Shortsellers bring new information to the market, increase liquidity, and reduce
bubbles (remember the housing bubble started this crisis) • Prohibiting shortselling does not solve the general funding problem. • Temporarily banning new short sales of financial institutions can be justified if there
is risk of predatory trading, but often firms on trouble look for scapegoats
Page 52
Conclusion: Liquidity Risk Lessons
Liquidity risk important for• security prices (liquidity-adjusted CAPM)• risk management• the speed of arbitrage
Funding liquidity of banks and “speculators” is a driver of market liquidity risk
Liquidity crisis:• Driven by liquidity spirals:
loss spiral margin spiralrisk management spiral
• Liquidity providers become demanders• New capital arrives slowly• Prices drop and rebound
Page 53
Related Papers
“Carry Trades and Currency Crashes,” Markus Brunnermeier, Stefan Nagel, and Lasse Heje Pedersen (2008)NBER Macroeconomics Annual, forthcoming. Link
“Market Liquidity and Funding Liquidity,” Markus Brunnermeier and Lasse Heje Pedersen (2008)Review of Financial Studies, forthcoming. Link
“Demand-Based Option Pricing,” Nicolae Garleanu, Lasse Heje Pedersen, and Allen Poteshman (2008)Review of Financial Studies, forthcoming. Link
“Valuation in Over-the-Counter Markets,” Darrell Duffie, Nicolae Garleanu, and Lasse H. Pedersen (2007) The Review of Financial Studies, vol. 20, no. 5, pp 1865-1900. Link
“Liquidity and Risk Management” Nicolae Garleanu and Lasse Heje Pedersen (2007)American Economic Review, P&P, 2007, vol. 97, no. 2, pp. 193-197. Link
“Slow Moving Capital,” Mark Mitchell, Lasse Heje Pedersen, and Todd Pulvino (2007)The American Economic Review, P&P, 2007, vol. 97, no. 2, pp. 215-220. Link
“Asset Pricing with Liquidity Risk,” Viral Acharya and Lasse Heje Pedersen (2005)Journal of Financial Economics, vol. 77, pp. 375-410. Link
“Predatory Trading,” Markus K. Brunnermeier and Lasse Heje Pedersen (2005)The Journal of Finance, vol. 60, no. 4, pp. 1825-1863. Link
“Liquidity and Asset Prices,” Yakov Amihud, Haim Mendelson, and Lasse Heje Pedersen (2005) Foundations and Trends in Finance, vol.1, no. 4, pp. 269-364. Link
“Securities Lending, Shorting, and Pricing,” Darrell Duffie, Nicolae Garleanu, and Lasse Heje Pedersen (2002)Journal of Financial Economics, vol. 66, pp. 307-339. Link