Peters (1989, 1994) of PanAgora Management suggests that, to understand financial turbulence, the dynamics of cash flows between the various market participants, within and between different asset markets, should be analyzed and measured more carefully. Although there exists not yet a complete theory of physical turbulence, let alone a theory of financial turbulence, many parallels between the two phenomena have been noted by, for example, Mandelbrot (1982, 1998).
Simultaneously, the accurate measurement of financial illiquidity and of financial illiquidity risk has gained in importance, as the example of the tax payer financed bail - out of the collapsed Long Term Capital Management (LTCM) hedge fund in 1998 demonstrates. This hedge fund applied a trading strategy known as convergence arbitrage, which is based on the idea that if two securities have the same theoretical price, because they have the same return risk profile, their market prices should eventually be the same. But this convergence strategy ignores the observation that financial risk is a time dependent phenomenon and not a time - independent phenomenon to which the usual central limit theory based on i.i.d. assumptions applies. Indeed, in the summer of 1998 LTCM made a huge $4 billion loss. This was triggered when Russia defaulted on its debt, which caused a flight to quality in the German bond market.
LTCM itself did not have a large exposure to Russian debt, but it tended to be long illiquid German (off - the - run) bonds and short the corresponding liquid German (on - the - run) bonds. The spreads between the prices of the illiquid bonds and the corresponding liquid bonds widened sharply after the Russian default. Credit spreads also increased and LTCM was highly leveraged, with a debt/equity ratio of close to 300, so that the loss of profits on its hedges immediately translated in a very rapid vanishing of its market valued equity and threatened bankruptcy. When it was unable to make its projected ”risk - free” arbitrage profits, it experienced huge losses and there were margin calls on its positions that it was unable to meet.
But LTCM did not operate in a vacuum. It operated in a particular financial environment. LTCM’s position was made more di¢cult by the fact that many other hedge funds followed similar convergence arbitrage strategies. When LTCM tried to liquidate part of its portfolio to meet its margin calls, by selling its illiquid off - the - run bonds and by buying its liquid on - the run bonds, other hedge funds faced with similar problems tried to do similar trades. The price of the on - the - run bonds rose relative to the price of the off - the run bonds. This caused the illiquidity spreads to widen even further and to reinforce the flight to quality. Thus the illiquidity problem was exacerbated and not alleviated. This was a clear example of long - term illiquidity risk dependence that was not foreseen by the time independence assumptions of geometric Brownian motion arbitrage models used by LTCM’s managers and partners.
Despite its obvious importance, the proper empirical measurement and analysis of liquidity and of illiquidity risk is still in its infancy. For example, there is still no agreement on how financial market liquidity should be measured. More precisely stated: there does not yet exist a measurement standard for the various degrees of financial liquidity. Which levels of financial illiquidity are prone to generate financial catastrophes, which levels of financial illiquidity allow regular, liquid trading activity, and which levels of ultra financial liquidity are prone to generate financial turbulence?
Therefore, in this paper we discuss the empirical measurement of the dynamics of market illiquidity, in particular of the illiquidity of cash flows, which is directly related to the dynamics of the term structure of rates of return on cash investments and to the concept of (bond and equity) duration.
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