Sufficient liquidity is vital for financial markets to perform, making it essential for the economy as a whole. A strong decline in liquidity in almost all of the major financial markets has been observed during the current financial crisis, and these liquidity effects also affect market prices. In cooperation with researchers from New York University, WU's Nils Friewald and Rainer Jankowitsch studied these effects on the US corporate bond market. Their results have now been published in the renowned Journal of Financial Economics.

"Reduced liquidity means that many financial instruments can either not be traded at all, or are burdened with very high transaction costs," explains WU researcher Nils Friewald. The current study analyzes these effects on the US corporate bond market, which is the major market for corporate financing in the US, with a total volume of over $ 5000 billion. The project focused mainly on the analysis of liquidity both during the current financial crisis and during the 2005 General Motors/Ford crisis.

Liquidity effects account for approximately 10% of explainable interest-rate premiums

In their study, the researchers broke down the premiums on risk-free interest rates which affect bond prices into two components: a risk component and a liquidity component. These premiums have almost doubled during the current crisis. The inherent liquidity risk can be quantified using the appropriate liquidity indices. "We observed that liquidity effects accounted for some 10% of the explainable premiums, and that the significance of liquidity increased significantly during both crises," says Rainer Jankowitsch.

Liquidity is a major risk component in financial markets during a crisis

The results show that liquidity is a central risk component that must be taken into account in the evaluation of financial instruments, risk management strategies, and the regulation of financial markets. The liquidity indices presented allow these effects to be quantified.
Contact:
Rainer Jankowitsch
Institute for Finance, Banking and Insurance
Tel: +43-1-31336 ext. 4340
rainer.jankowitsch@wu.ac.at
http://www.wu.ac.at/finance