Anticipated Liquidity Shock and Financial Market Equilibrium

Vikram Kumar ()
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Vikram Kumar: Department of Economics, Davidson College

No 14-08, Working Papers from Davidson College, Department of Economics

Abstract: This paper examines the effect of liquidity shocks on international interest arbitrage to examine if persistent excess returns exist in international financial markets as indicated by a large body of literature on the forward discount puzzle. The prospect of losses entailed by liquidating assets prior to maturity in liquidity-constrained markets changes arbitragers’ ex-ante assessments of returns from holding domestic and foreign securities. It is shown that a high interest asset entails high loss conditional on a liquidity shock so that a liquidity discount attaches to the high interest asset. Investors are therefore willing to hold the low interest asset even if the currency of its denomination is expected to depreciate, or not appreciate sufficiently to offset the interest rate differential. The liquidity discount is characterized, and empirical support is provided using about thirty years of monthly data on five major currencies.

JEL-codes: F31 (search for similar items in EconPapers)
Date: 2014-12
New Economics Papers: this item is included in nep-mst
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