A Study of Financial Market Frictions and Their Impacts on Financial Intermediaries and the Macroeconomy
Lead Research Organisation:
University of York
Department Name: Economics
Abstract
This research looks into the market frictions that prevent sufficient arbitrage activity and could possibly lead to financial market fragility and severe crisis. Arbitrage refers to the practice of exploiting mispricing opportunities, which is conducted by rational and sophisticated investors, e.g. hedge funds. Effective arbitrage ensures that the financial market infrastructure is efficient and well-functioning, which is critical to the UK economy and productivity. However, due to several market frictions such as risk management, fee structure and funding constraint faced by fund managers, arbitrage is limited, mispricings persist, and more severely financial crises can be triggered. Extensive research on limits to arbitrage have been carried out with focus on the size of mispricing, but many questions and limitations are unsolved: (i) what is the combined impact of various arbitrage frictions on market efficiency; (ii) what is the dominating friction that limits arbitrage at a certain period; (iii) whether it is possible to identify the potential market vulnerability from data. Answering these questions is crucial to the policy-makers, e.g. Bank of England, in supervising and regulating the financial market infrastructures to ensure a smooth functioning of the UK economy and making appropriate monetary policy to influence activities in the economy. In keeping with the fast-developing financial market and the vast demand for appropriate supervision, understanding of what lies behind the limits to arbitrage requires more knowledge of market dynamics.
To address these issues, this research conducts theoretical studies and empirical applications to analyze the two distinct market frictions that limit arbitrage: cost/risk management and funding (il)liquidity. Large arbitrage costs render arbitrageurs unwilling to conduct arbitrage, while funding illiquidity reduces their ability to raise sufficient funds to conduct arbitrage. Under certain conditions, severe funding illiquidity triggers the amplification machanism that describes how a moderate event can propagate into a large spillover across the financial system. From the theoretical aspect, the research proposes to investigate market frictions via the arbitrage activity implemented to correct mispricing. First, it reveals the combined effect of the market frictions on the arbitrage activity and asset pricing dynamics, which offers an novel approach to identify the dominating friction of the two, and more importantly, to measure the level of funding illiquidity in the market and signal the occurrence of amplification. By the empirical application in the US market, the results demonstrate the dominance of funding illiquidity and the existence of amplification effect during the major financial crises events in recent years, which provides an early warning signal of potential failure in financial market infrastructure and guides the direction and timing of the policy decision.
Throughout this fellowship, efforts will be made to further enhance this research: consulting with real life arbitrageurs, e.g. hedge funds, to understand how market frictions tend to affect their activity and how they overcome these frictions; communicating with policy-makers and regulators, e.g. Bank of England, to understand their opinions on market frictions and identify the information in need. Efforts will also be made to disseminate the finding of this research to potential users and beneficiaries through conference presentation, journal publication, networking, research visit, social media coverage and report disclosed in web page.
To address these issues, this research conducts theoretical studies and empirical applications to analyze the two distinct market frictions that limit arbitrage: cost/risk management and funding (il)liquidity. Large arbitrage costs render arbitrageurs unwilling to conduct arbitrage, while funding illiquidity reduces their ability to raise sufficient funds to conduct arbitrage. Under certain conditions, severe funding illiquidity triggers the amplification machanism that describes how a moderate event can propagate into a large spillover across the financial system. From the theoretical aspect, the research proposes to investigate market frictions via the arbitrage activity implemented to correct mispricing. First, it reveals the combined effect of the market frictions on the arbitrage activity and asset pricing dynamics, which offers an novel approach to identify the dominating friction of the two, and more importantly, to measure the level of funding illiquidity in the market and signal the occurrence of amplification. By the empirical application in the US market, the results demonstrate the dominance of funding illiquidity and the existence of amplification effect during the major financial crises events in recent years, which provides an early warning signal of potential failure in financial market infrastructure and guides the direction and timing of the policy decision.
Throughout this fellowship, efforts will be made to further enhance this research: consulting with real life arbitrageurs, e.g. hedge funds, to understand how market frictions tend to affect their activity and how they overcome these frictions; communicating with policy-makers and regulators, e.g. Bank of England, to understand their opinions on market frictions and identify the information in need. Efforts will also be made to disseminate the finding of this research to potential users and beneficiaries through conference presentation, journal publication, networking, research visit, social media coverage and report disclosed in web page.
Organisations
| Description | Summary: In the first 6 months, I have achieved the fellowship objectives as proposed. Majority of the time has been devoted to preparation for publication, training for data analysis and further research. In particular, I have submitted one of my research paper to journal after revision and collaborated with scholar from Kent Business School to revise another paper of mine. Details are as follows. Publication: (i) My submission to Management Science was, unfortunately, rejected after being reviewed for over 9 months. The results are mixed with some positive and helpful feedback. I have carried on a second round of revision with my co-authors and my mentor to address the questions raised by the referees. The revision has been completed in February and the paper is submitted to and currently under review in Review of Financial Studies for publication. (ii) I have invited Dr Huamao Wang from Kent Business School, University of Kent, for collaboration on another chapter of my dissertation. We have (1) improved the empirical methodology to better capture the spot-future basis and to address the coherence issue between over- and under-pricing; (2) updated our dataset with more control variables from the stock market; (3) provided extra empirical evidence to link the stock market and treasury bond market liquidity; (4) added empirical evidence from major European and Asian markets to demonstrate the robustness of our results. Our revision is still in progress. Conference: (i) I have attended the AEA / AFA conference in the U.S. in January 2019, where I have communicated with a number of leading scholars from my research field. (ii) I have involved in organizing the Asset Pricing workshop to be held at the University of York in June. I have invited Professor Dimitri Vayanos from London School of Economics, a renowned researcher in limits to arbitrage, for keynote speech. A number of researchers in central banks are also invited to take part for presentation and discussion. (iii) I have applied to attend and present my paper in several high quality conferences to be held in the coming 6 months. In particular, I have applied to attend the Twelfth Annual Conference of the Paul Woolley Centre for study of capital market dysfunctionality in June for subjects related to the frictions in the financial market and the role of financial intermediaries. It collaborates with the Bank for International Settlements, which provides a chance to communicate and disseminate my research to the central banks. Training: I have enrolled in two Matlab training modules since January 2019: Matlab for financial applications and Matlab for data processing and visualization. These courses will be completed by the end of March. Further research: A part of my time have been devoted to further research in the foreign exchange (FX) market with my mentor. I have attempted to explore the covered interest rate parity (CIP), which forms a no-arbitrage condition in international finance. Failures in CIP reflect the dysfunction of financial market infrastructure and impose extra costs to firms when hedging against their exchange rate risk. I have completed a draft of research proposal, which will be used for application of research visit and further funding opportunities from April. The proposal contains (1) a literature review on the role of the dollar on global liquidity and the failure of CIP; (2) a brief theory on the linkage between currency exchange-traded funds (ETF) arbitrage and CIP violation; (3) data collected from the foreign exchange market (G10 countries), the interbank lending market (G10 countries) and the ETF markets (both U.S. and the UK); (4) some preliminary empirical evidence of the connectedness between FX and ETF markets. Other activities: (i) I have been constantly meeting with my mentor in the last 6 months, discussing the revision for publication and further research on CIP. (ii) I have attended and discussed in the UKRI Infrastructure Roadmap Roundtable at Durham in March. In the meeting we have share views on future needs, issues and gaps in data infrastructure for social and economic research, which helps to draft the new data infrastructure strategy this year. |
| Exploitation Route | Due to the importance of financial market infrastructure to the UK economy and productivity, the social impact of this research should be intriguing and benefits the policy-makers and regulators on the financial market, the hedge fund industry, and individual investors and firms who rely heavily on financial services. The Bank of England has constantly supervised and regulated the financial market and implemented unconventional monetary policy through the financial market, the efficacy of which crucially depends on the functioning and stability of the financial market infrastructure. This research provides new insight into the understanding of the financial market frictions, which helps policy-makers distinguishing the causes of market inefficiency and improves market functioning with appropriate policy. My impact plan in the first 6 months focuses on contacting with the policy-makers and regulators, while I will engage with other potential users in the coming months with the proposed impact plan. To communicate with policy-makers and regulators, I (1) have organized workshop and invited speakers from central banks for intensive discussions on financial market efficiency; (2) have applied to present and disseminate my work to policy-makers in the central bank conferences; (3) will apply to visit the research unit in central bank for discussions, collaboration and data access, with the research proposal I completed on the CIP violation. |
| Sectors | Financial Services, and Management Consultancy |