Liquidity risk and derivative markets: Lessons from the crisis and insights for the future

Summary

The ongoing credit crisis has clearly shown how the lack of liquidity in financial markets can have a dramatic impact on market prices and amplify the severity of a crisis. At the core of the crisis are financial derivative products traded in the over-the-counter market (such as mortgage-backed securities). The fast development of this market has created a situation where regulators, financial institutions and scientists do not fully understand several key aspects of these markets and products. In particular, little is know about the interaction between liquidity risk and derivative prices. This project aims to provide a deep understanding of how liquidity risk impacts financial decision making and prices in financial markets, with a particular focus on derivative markets.

The proposal consists of four subprojects. In the first project I develop empirical methods to measure liquidity risk in derivative markets, where the challenge is to deal in an optimal way with the irregular and heterogeneous nature of the data. Second, I study how the presence of liquidity risk in derivative markets affects the optimal portfolio choice of investors such as pension funds, banks, and hedge funds, incorporating that some investors are subject to regulatory constraints. Third, I develop a general equilibrium framework to understand the effect of liquidity risk on derivative prices. Finally, I empirically test the equilibrium implications of liquidity risk on the prices of derivatives.

The results of this project have important implications for how central banks, governments and other regulators should deal with liquidity risk and derivatives when setting regulatory restrictions for financial institutions. Current regulation does not incorporate liquidity and liquidity risk. Financial institutions can also directly use the insights from this research project to better deal with liquidity risk in their pricing of derivatives and financial risk management.

Output

Thesis

Scientific article

  • O. van Hemert, J.J.A.G. Driessen(2011): Pricing of Commercial Real Estate Securities during the 2007-2009 Financial Crisis Journal of Financial Economics forthcoming pp. 00 - 00
  • J. Driesse, D. Bongaerts, F. de Jong(2011): Derivative Pricing with Liquidity Risk: The Journal of Finance pp. 203 - 240
  • F. de Jong, J.J.A.G. Driessen, D. Bongaerts(2011): An Asset Pricing Approach to Liquidity Effects in Corporate Bond Markets SSRN Working Paper pp. 00 - 00
  • P. Tuijp, J.J.A.G. Driessen, A. Beber(2011): Pricing Liquidity Risk with Heterogeneous Investment Horizons SSRN Working Paper pp. 00 - 00
  • J. Driessen, D. Bongaerts, F. de Jong(2011): Derivative Pricing with Liquidity Risk: , Dion Bongaerts, Frank de Jong and Joost Driessen Journal of Finance pp. 203 - 240
  • J. Driessen, O Van Hemert(2012): Pricing of commercial real estate securities during the 2007-2009 financial crisis Journal of Financial Economics pp. 37 - 61
  • J.J.A.G. Driessen, T. Nijman, Z. Simon(2014): The Missing piece of the Puzzle: Liquidity Premiums in Inflation-indexed Markets SSRN Working paper pp. 00 - 00
  • Z. Simon(2015): Not risk free: The relative pricing of Euro area inflation-indexed and nominal bonds SSRN Working paper pp. 00 - 00
  • F. de Jong, J. Driessen, D. Bongaerts(2017): An Asset Pricing Approach to Liquidity Effects in Corporate Bond Markets Review of Financial Studies pp. 1229 - 1269

Professional publication

  • Tse-Chun Lin, Xiaolong Lu, J. Driesse(2012): Why do option prices predict stock returns?
  • J.J.A.G. Driessen(2014): Illiquiditeit voor pensioenfondsen en verzekeraars: Rendement versus risico
  • F. de Jong, J.J.A.G. Driessen(2015): Can Large Long-term Investors Capture Illiquidity Premiums? pp. 34 - 60

Publication meant for a broad audience

  • J. Driessen(2010): Liquidity Risk in Financial Markets

Details

Project number

452-09-002

Main applicant

Prof. dr. J.J.A.G. Driessen

Affiliated with

Tilburg University, Tilburg School of Economics and Management (TiSEM), Finance

Team members

Prof. dr. J.J.A.G. Driessen, P. Tuijp MSc, R. Xing

Duration

01/06/2010 to 25/11/2015