Transmission of Monetary Policy with Heterogeneity in Household Portfolios

This paper assesses the importance of heterogeneity in household portfolios for the transmission of monetary policy in a New Keynesian business cycle model with uninsurable income risk and assets with different liquidity. In this environment, monetary transmission works through investment, but redistribution lowers the elasticity of investment via two channels: (i) heterogeneity in marginal propensities to invest, and (ii) time variation in the liquidity premium. Monetary contractions redistribute to wealthy households who have high propensities to invest and a low marginal value of liquidity, thereby stabilizing investment. I provide empirical evidence for countercyclical liquidity premia and heterogeneity in household portfolio responses. (JEL E12, E32, E52, G11, G51)

Equilibrium asset pricing with transaction costs

We study risk-sharing economies where heterogeneous agents trade subject to quadratic transaction costs. The corresponding equilibrium asset prices and trading strategies are characterised by a system of nonlinear, fully coupled forward–backward stochastic differential equations. We show that a unique solution exists provided that the agents’ preferences are sufficiently similar. In a benchmark specification with linear state dynamics, the empirically observed illiquidity discounts and liquidity premia correspond to a positive relationship between transaction costs and volatility.

Inflation Expectations and Risk Premia in Emerging Bond Markets: Evidence from Mexico

To study inflation expectations and associated risk premia in emerging bond markets, this paper provides estimates for Mexico based on an arbitrage-free dynamic term structure model of nominal and real bond prices that accounts for their liquidity risk. In addition to documenting the existence of large and time-varying liquidity premia in nominal and real bond prices that are only weakly correlated, the results indicate that long-term inflation expectations in Mexico are well anchored close to the inflation target of the Bank of Mexico. Furthermore, Mexican inflation risk premia are larger and more volatile than those in Canada and the United States.

Incomplete Information and the Liquidity Premium Puzzle

We examine the problem of an investor who trades in a market with unobservable regime shifts. The investor learns from past prices and is subject to transaction costs. Our model generates significantly larger liquidity premia compared with a benchmark model with observable market shifts. The larger premia are driven primarily by suboptimal risk exposure, as turnover is lower under incomplete information. In contrast, the benchmark model produces (mechanically) high turnover and heavy trading costs. We provide empirical support for the amplification effect of incomplete information on the relation between trading costs and future stock returns. We also show empirically that such amplification is not driven by turnover. Overall, our results can help explain the large disconnect between theory and evidence regarding the magnitude of liquidity premia, which has been a longstanding puzzle in the literature. This paper was accepted by Kay Giesecke, finance.

Private and public liquidity provision in over‐the‐counter markets

We show that trade frictions in over‐the‐counter (OTC) markets result in inefficient private liquidity provision. We develop a dynamic model of market‐based financial intermediation with a two‐way interaction between primary credit markets and secondary OTC markets. Private allocations are generically inefficient due to a congestion externality operating through market liquidity in the OTC market. This inefficiency can lead to liquidity that is suboptimally low or high compared to the second best, providing a rationale for the regulation and public provision of liquidity. Moreover, our model characterizes a transmission channel of quantitative easing or tightening that operates through liquidity premia.

Excess liquidity premia of single-name CDS vs iTraxx/CDX spreads: 2007-2017

Purpose The aim of this research is twofold. First, we study average levels of liquidity for long-run through-the-cycle periods, which potentially allow eliminating procyclicality from risk parameters used for expected credit-loss calculations. Second, we investigate to what extent the relative illiquidity of individual credit default swap (CDS) contracts affects their spreads in comparison with the respective CDS indices. Design/methodology/approach Based on the iTraxx Europe CDS index covering European firms and the CDX North America CDS index covering US firms, as well as on individual CDS transactions involving the reference entities constituting these two benchmark indices, we investigate the excess liquidity premia in spreads of the single-name CDS contracts over the spreads of the iTraxx and CDX indices over 2007-2017. Findings First, single-name CDS excess liquidity premia depend on CDS contract maturity. Second, the long-run average spread of a benchmark index may stay as low as three-fourths of the respective long-run average of the mean of the single-name CDS spreads, meaning that the excess liquidity premium may be as high as one-fourth of the firm-specific CDS spread. Third, the term structure of the excess liquidity differs between the Europe and North America geographies. Fourth, on average, the excess liquidity premia in the single-name CDS spreads over the respective CDS indices diminish with increasing maturities of CDS contracts. Originality/value No previous research addresses differences between the liquidity component in a benchmark CDS index spreads and the mean spread averaged across the constituents of the index. Our work fills this gap.

Search-based Endogenous Asset Liquidity and the Macroeconomy

We develop a search-theory of asset liquidity which gives rise to endogenous financing constraints on investment in an otherwise standard dynamic general equilibrium model. Asset liquidity describes the ease of issuance and resaleability of private financial claims, which is the outcome of a costly search-and-matching process for such claims implemented by financial intermediaries. Limited liquidity of private claims creates a role for liquid assets, such as government bonds, to ease financing constraints. We show that endogenising liquidity is essential to generate positive co-movement between asset liquidity and asset prices. When the cost of intermediating funds to entrepreneurs rises, investment and output fall whereas the hedging value of liquid assets increases, driving up liquidity premia. In the United States, such intermediation cost shocks can account for at least 37% of the variation in output, and more than 78% of the variation in liquidity premia.