Essays in Liquidity and Financial Markets
This thesis presents three studies related to the effects of liquidity on financial markets. The first topic explores the relationship between funding liquidity and credit default swap (CDS) spreads. Using panel estimations, this study provides evidence that a tightening of funding liquidity increases spreads, effect which is three times larger in magnitude for high-CDS entities compared to low-CDS firms. Moreover, this paper highlights the impact of the 'CDS Small Bang' regulatory changes, especially the introduction of fixed coupons which induced upfront fees for trading CDSs. We find that after the introduction of the fees, funding liquidity changes have a much larger and more significant impact on CDS spread changes. The second study presents an empirical investigation of the theoretical predictions of Brunnermeier and Pedersen (2009) connecting funding liquidity with market liquidity and volatility and an extension of these linkages to CDS spreads. Specifically, in a European context, this paper documents that: (i) funding conditions co-move with illiquidity, volatility and CDS spreads, (ii) during tight funding conditions, illiquid, volatile and high-CDS spread securities become particularly illiquid, (iii) a tightening of funding liquidity increases CDS spreads, this effect being stronger if funding conditions were already constrained, (iv) a deterioration of funding liquidity decreases contemporaneous returns , and (v) funding shocks are priced in the cross-section of illiquidity-sorted portfolios The third study examines the relationship between monetary policy and stock liquidity, in the context of the U.K. market. In line with the inventory paradigm of market microstructure and theories linking capital constraints with market illiquidity, this study documents that a con tractionary (expansionary) monetary policy reduces (increases) stock liquidity. Moreover, this study finds that the effect of monetary policy on stock liquidity depends on the liquidity proxies chosen, decreases with firm size , increases with firm volatility, and is stronger during the 2007-2009 financial crisis.
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