Noise as Information for Illiquidity

Abstract

We propose a market-wide liquidity measure by exploiting the connection between the amount of arbitrage capital in the market and observed "noise" in U.S. Treasury bonds-the shortage of arbitrage capital allows yields to deviate more freely from the curve, resulting in more noise in prices. Our noise measure captures episodes of liquidity crises of different origins across the financial market, providing information beyond existing liquidity proxies.Moreover, as a priced risk factor, it helps to explain cross-sectional returns on hedge funds and currency carry trades, both known to be sensitive to the general liquidity conditions of the market. * Hu is from Faculty of Business and Economics, University of Hong Kong, and Pan (corresponding author) and Wang are from MIT Sloan School of Management, CAFR, and NBER. We are grateful to Cam Harvey (the Editor), the associate editor, two anonymous reviewers, Darrell Duffie, Mark Kritzman, Krishna Ramaswamy, Dimitri Vayanos, Adrien Verdelhan, and Haoxiang Zhu for valuable discussions. We also thank comments from seminar participants at Boston University, Shanghai University of The level of liquidity in the aggregate financial market is closely connected to the amount of arbitrage capital available. During normal times, institutional investors such as investment banks and hedge funds have abundant capital, which they can deploy to supply liquidity.Consequently, big price deviations from fundamental values are largely eliminated by arbitrage forces, and assets are traded at prices closer to their fundamental values. During market crises, however, capital becomes scarce and/or willingness to deploy it diminishes, and liquidity in the overall market dries up. The lack of sufficient arbitrage capital limits arbitrage forces and assets can be traded at prices significantly away from their fundamental values.1 Thus, temporary price deviations, or noise in prices, being a key symptom of shortage in arbitrage capital, contains important information about the amount of liquidity in the aggregate market.In this paper, we analyze the noise in the price of U.S. Treasuries and examine its informativeness as a measure of overall market illiquidity.Our basic premise is that the abundance of arbitrage capital during normal times helps smooth out the Treasury yield curve and keep the average dispersion low. This is particularly true given the presence of many proprietary trading desks at investment banks and fixedincome hedge funds that are dedicated to relative value trading with the intention to arbitrage across various habitats on the yield curve.2 During liquidity crises, however, the lack of arbitrage capital forces proprietary trading desks and hedge funds to limit or even abandon their relative value trades, leaving the yields to move more freely in their own habitats and resulting in more noise in the yield curve. We argue that abnormal noise in Treasury prices is a symptom of a market in severe shortage of arbitrage capital. More importantly, to the extent that capital is...

Price discovery and persistent arbitrage violations in credit markets

“…Past studies have suggested several important sources of arbitrage frictions: funding cost and constraints (Brunnermeier & Pedersen, 2009;Fontaine & Garcia, 2012), volatility (Pontiff, 2006) (Hu, Pan, & Wang, 2013;Kapadia & Pu, 2012), and counterparty risk (Gorton and Metrick, 2012;Mitchell & Pulvino, 2012). We select variables related to these arbitrage impediments to perform empirical tests.…”

“…Table 3 reports mean values of market-wide impediment variables for the normal and crisis periods, where the normal period includes both pre-and postcrisis periods. Results show that funding cost and constraints, TA B L E 3 Impediments to arbitrage and market integration Hu et al (2013); VIX is the volatility index; PSB is Pastor-Stambaugh bond liquidity index; PDCDS is the average rate of the CDS against primary dealers; LOIS is the yield spread between Libor and OIS rates; DPDPL is the change in net long-term security holdings by primary dealers; and CF is the net convertible fund flow. CSF measures the cash shortfall of primary dealers using the method in Daniel et al (2017).…”

Official Demand for U.S. Debt: Implications for U.S. Real Rates

“…This effect, however, is in part captured by our liquidity component. Indeed, the average fitting errors proxy for the slow moving capital, which is intimately linked with liquidity conditions in the bond market (Hu, Pan, and Wang 2013). liquidity conditions affect the level and dynamics of real rates. As a result, we include an (il)liquidity factor, so that real rates are driven by three factors: the X t =[r t , β t ] factors and the illiquidity factor l t .…”

Measuring the Liquidity Profile of Mutual Funds

“…In the case of fixed-income funds, we proxy for aggregate liquidity with the noise measure introduced by Hu, Pan, and Wang (2013). We use the negative of the measure so that higher values imply better liquidity conditions.…”

“…Then the yield curve is used to price all available bonds on a given day. The noise measure is the root mean squared deviation of the model-implied and observed yields (for details, see Hu, Pan, and Wang, 2013).…”