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Anticipated Liquidity Shock and Financial Market Equilibrium

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  • Vikram Kumar

    (Department of Economics, Davidson College)

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.

Suggested Citation

  • Vikram Kumar, 2014. "Anticipated Liquidity Shock and Financial Market Equilibrium," Working Papers 14-08, Davidson College, Department of Economics.
  • Handle: RePEc:dav:wpaper:14-08
    as

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    References listed on IDEAS

    as
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    5. Martin D. D. Evans & Karen K. Lewis, 2017. "Do Long-Term Swings in the Dollar Affect Estimates of the Risk Premia?," World Scientific Book Chapters, in: Studies in Foreign Exchange Economics, chapter 3, pages 59-99, World Scientific Publishing Co. Pte. Ltd..
    6. Chakraborty, Avik & Evans, George W., 2008. "Can perpetual learning explain the forward-premium puzzle?," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 477-490, April.
    7. Philippe Bacchetta & Eric van Wincoop, 2010. "Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle," American Economic Review, American Economic Association, vol. 100(3), pages 870-904, June.
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    9. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2009. "Carry Trades and Currency Crashes," NBER Chapters, in: NBER Macroeconomics Annual 2008, Volume 23, pages 313-347, National Bureau of Economic Research, Inc.
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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange

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