The global financial crisis highlighted the importance of ensuring that the financial system has adequate liquidity to withstand adverse circumstances. The funding pressures that began in 2007 underlined the acute deficiencies in the liquidity-risk-management practices of some banks, and the severity of the ensuing crisis required massive public sector support to stem the liquidity spiral and m...

This paper contributes to the debate about the extent to which liquidity risk affects asset prices. Motivated by evidence on downward liquidity spirals, flights to liquidity and investor perceptions of risk, we develop and test a liquidity-adjusted capital asset pricing model in which the key innovation is separating liquidity risk into asymmetric upside and downside risks. Our model bridges th...

The importance of maintaining sufficient liquidity in financial markets is emphasised strongly in the academic literature. During the 1990s the United Kingdom monetary authorities introduced a number of structural reforms in the government bond market, aimed at improving secondary market liquidity. In this paper we examine the impact of the reforms by attempting to ascertain if liquidity levels...

Using a large data set on credit default swaps, we study how default risk interacts with interest-rate risk and liquidity risk to jointly determine the term structure of credit spreads. We classify the reference companies into two broad industry sectors, two broad credit rating classes, and two liquidity groups. We develop a class of dynamic term structure models that include (i) two benchmark ...

The recent financial crisis has shown that liquidity risk is far more important and intricate than regulators had previously acknowledged. The shift from bankbased to market-based financial systems and from deferred net settlement systems to liquidity-demanding real-time gross settlement of payments explains some of the shortcomings of traditional liquidity risk management. Although liquidity r...

This paper explores the role of liquidity risk in the pricing of corporate bonds. We show that corporate bond returns have significant exposures to fluctuations in treasury bond liquidity and equity market liquidity. Further, this liquidity risk is a priced factor for the expected returns on corporate bonds, and the associated liquidity risk premia help to explain the credit spread puzzle. In t...

This research seeks statistical commonalities in market liquidity across a range of corporate equities and bond markets and commodity futures markets, with an aim to better understanding system-level patterns in aggregate or funding liquidity that arise from broad patterns in market liquidity. We present a Bayesian estimation of hidden Markov chain (HMC) models to measure the latent structure o...

This paper proposes a new non-parametric method for estimating model-free, time-varying liquidity betas which builds on realized covariance and volatility theory. Working under a liquidityadjusted CAPM framework we provide evidence that liquidity risk is a factor priced in the Greek stock market, mainly arising from the covariation of individual liquidity with local market liquidity, however, t...

This paper studies the pricing of liquidity risk in the cross section of corporate bonds for the period from January 1994 to March 2009. The average return on bonds with high sensitivities to aggregate liquidity exceeds that for bonds with low sensitivities by about 4% annually. The positive relation between expected corporate bond returns and liquidity beta is robust to the effects of default ...

We study the interplay between corporate liquidity and asset reallocation. Our model shows that financially distressed firms are acquired by liquid firms in their industries even in the absence of operational synergies. We call these transactions ‘‘liquidity mergers,’’ since their purpose is to reallocate liquidity to firms that are otherwise inefficiently terminated. We show that liquidity mer...