Essays on Financial Liquidity and Risk

Abstract

This thesis is a collection of essays on financial liquidity and risk. The first two essays investigate the liquidity, liquidity premia, and liquidity risk premia of corporate bonds. The third essay examines the risk exposures of hedge fund strategies. The first two essays are single-authored, while the third is coauthored with William Kinlaw, John Papp, and David Turkington.

The first essay examines the liquidity and liquidity risk premia of investment-grade corporate bonds. I build on standard continuous-time structural credit models by incorporating an illiquid secondary market for bonds and by allowing this illiquidity to co-vary with Markov risk regimes. Then, using TRACE corporate bond transaction data from 2003 to 2011, two alternative measures of illiquidity, and consumption-liquidity regimes inferred from the data, I show that liquidity and liquidity risk have significant explanatory power in bond yield spreads, both in a reduced-form regression analysis, and in a structural model-calibration analysis. This effect is present both within and across bond rating classes, and is substantially stronger in the period following the 2007-2009 financial crisis.

The second essay explores whether on-the-run corporate bonds are more liquid than comparable off-the-run bonds, and whether this liquidity carries a premium. Using corporate bond issuance and transaction data, I measure the monthly liquidities of 504 bonds from 36 distinct issuers. In a panel regression analysis, I show that on-the-run bonds are substantially more liquid than comparable off-the-run bonds, where liquidity is measured by volume traded, frequency of transactions, and implied bid-ask spread. To investigate the existence of a liquidity premium, I compare yields of portfolios containing on-the-run bonds with the yields of portfolios containing off-the-run bonds. I find weak evidence that an average spread of 5-8 basis points exists. More interestingly, I find that the spread explodes in October 2008, potentially reflecting a flight-to-liquidity phenomenon that is consistent with other time-series studies of aggregate liquidity.

The third essay examines non-linearities in the risk exposures of hedge fund returns. We analyze the exposures of six broadly defined hedge-fund strategies to a diverse collection of risk factors, including equity markets, commodities, Fama-French factors, credit risk, and options. The analysis extends the existing literature in two ways: by looking at monthly hedge fund strategy returns through the 2008 crisis period, and by analyzing recently available daily hedge fund strategy returns. In contrast to previous research, we find that for monthly returns, at-the-money and close to at-the-money put options on the S\&P500 index are not correlated with hedge funds strategies. However, many of the hedge fund monthly returns, as well as many of the daily returns, are negatively correlated with deeper out-of-the-money puts.