Interaction of Funding Liquidity Risk and Market Liquidity Risk - Assignment Example

Interaction of Funding Liquidity Risk and Market Liquidity Risk Introduction The main focus of this study is to study market liquidity risk and bank funding liquidity risk measurements. The main objective is to determine the type of interaction or relationship between these two variables. It is very important to understand how market liquidity and funding liquidity interact since they lead to favorable conditions when they interrelate with each other. The data set used in this study is related to several banks that do operate in various parts of the world and this enabled the understanding of the interaction of these two variables that include funding liquidity and market liquidity risk. The dataset includes information about stock return, return on equity, and return on assets, total bank assets and amihud index. Test Design The data set used in this study is related to several banks that do operate in various parts of the world and this enabled the understanding of the interaction of these two variables that include funding liquidity and market liquidity risk. Firstly correlation analysis was undertaken between certificate of deposits for banks (funding liquidity risk) and Amihud index (market liquidity risk).Regression analysis was as well undertaken between these two variables. In addition, for further studies, a regression analysis could be performed between the dependent variable which was certificates of deposit and the independent variables that include, total asset, stock returns, Amihud index and return on assets. Review design Literature on the interaction between the funding liquidity risk and market liquidity risk was searched on internet through Google. Important journals related to the topic were selected and summarized. The key words such as measurement of market liquidity risk and funding liquidity risk; the relationship between market liquidity risk and funding liquidity risk were used when searching the literature online. Results and further tests The below results from correlation analysis indicate that there is a positive correlation between the market liquidity risk and the funding liquidity risk during the given period. The positive correlation is indicated by 0.08 as the coefficient value between these two variables. It is also seen that the correlation between these two variables is significant since the p value is less than 0.05.The variable of market liquidity and funding liquidity have been represented by Amihud index and the volume of assets. Correlations Amihud_index cds Amihud_index Pearson Correlation 1 .081** Sig. (2-tailed) .000 N 2013 2013 cds Pearson Correlation .081** 1 Sig. (2-tailed) .000 N 2013 2013 **. Correlation is significant at the 0.01 level (2-tailed). Basing on the regression analysis results below where, Amihud index was taken as dependent variable and the certificates of deposit represented independent variable. The applied model indicates no satisfactory results because the R squared value is too small to represent variations in the data. However, the results indicate a positive coefficient value and the p value is seen to be less than 0.05. Variables Entered/Removeda Model Variables Entered Variables Removed Method 1 cdsb . Enter a. Dependent Variable: Amihud_index b. All requested variables entered. Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate 1 .081a .007 .006 .0032988 a. Predictors: (Constant), cds ANOVAa Model Sum of Squares df Mean Square F Sig. 1 Regression .000 1 .000 13.207 .000b Residual .022 2011 .000 Total .022 2012 a. Dependent Variable: Amihud_index b. Predictors: (Constant), cds Coefficientsa Model Unstandardized Coefficients Standardized Coefficients t Sig. B Std. Error Beta 1 (Constant) .001 .000 16.962 .000 cds 6.523E-007 .000 .081 3.634 .000 a. Dependent Variable: Amihud_index Literature review Before analyzing the funding liquidity measurement, it is important to describe funding liquidity risk. Funding liquidity can be defined as the capacity of the banking institutions to implement their liabilities as they are (BIS, 2008).The empirical and theoretical literature review regarding funding liquidity risk indicates that funding liquidity risks increase is a reflection of an increased bids valuation in the market as traders and investors expect more return that is for higher risk assets. There has been an introduction of the adjusted bid for normalizing the price of the bid. And this is employed in measuring the liquidity funding risk (Drehmann and Nikolaou 2008).Based on the funding liquidity risks discussion above, understanding as well as describing the market liquidity risk has been made simple and it can be defined as the capacity of traders to buy or sell assets in the market without any influence of the prices as well as at a costs that is relatively low(Hooker and Kohn 1994).Market liquidity is seen to be associated directly to the asset cost in the market. It is considered to be the a bid ask spread which determined the losses that results from asset selling in the market as well as purchasing it again at the same moment. Market depth is considered to be another factor that is linked to market liquidity where, it is the number of asset units which traders wish to trade at the same time keeping an eye on the current prices, e.g. for ask and bid on condition that the unit prices remain the same. In this case, if there is greater market depth, then the prices could be altered if there is placement of big quantities of orders. Another concept is seen to be market resiliency Brunnemeier and Petersen (2007) noted that, there exists a strong relationship between market liquidity risks and funding liquidity risk .They as well noted that there can be a decline in the asset prices traded in cases of funding constraints faced by the banks. This could lead to a funding liquidity risk. In such cases, asset prices decline will lead to increased margin calls and it will mean that there is an increase in funding liquidity risk. The banks try to sell more assets to maintain their liquidity position and by doing this, it will result to asset prices decline as well as higher margin calls. The interaction that is between the market liquidity risk and the funding liquidity risk is seen to play major role financial crisis stimulation on a larger canvas. Drehmann and Nikolaou (2008) undertook and empirical investigation to found out the interaction effect between the market and funding liquidity risk. Hence, the investigation was based on the relationship between the index for European central bank (market liquidity) and the liquidity risk proxy. The findings revealed that there is a positive and directly proportional relationship between the both risks. Reflections on the results and suggestions for further tests The study objective was met where the interaction between market and funding liquidity risk were determined. Basing on the results, it was concluded that there is a positive association between this two variables, hence this findings were in agreement with the past studies or literature. For instance, Brunnemeier and Petersen (2007) noted that, there exists a strong relationship between market liquidity risks and funding liquidity risk .They as well noted that there can be a decline in the asset prices traded in cases of funding constraints faced by the banks. This could lead to a funding liquidity risk. The relationship between the funding liquidity risk and market liquidity risk is seen to be very weak (0.08) and this is not in line with the literature which indicates that there is a strong relationship between the two variable (Brunnermeier and Pedersen 2007). These differences can be resolved by doing Meta analysis which is considered to be appropriate study for such cases. In the end, a conclusion can be made based on the selected literature or recent and past studies undertaken. If further study is to be undertaken, then it should be based on the latest data set since this dataset used was for the financial year from 2003 to 2011. The interaction that is between the market liquidity risk and the funding liquidity risk is seen to play major role in financial crisis stimulation on a larger canvas. References Brunnermeier, M., & Pedersen, H. L. (2007). Market Liquidity and Funding Liquidity. The Review of Financial Studies. BIS. (2008). Liquidity Risk: Management and Supervisory Challenges. Basel Committee on Banking Supervision. Drehmanna, M., & Nikolaou, K. (2008). Funding Liquidity Risk: Definition and Measurement. Munich: Deutsche Bundesbank. Read More