Market implied funding liquidity and asset prices

Abstract

This study examines a market-wide liquidity measure based on systematic deviations from Put-Call parity in US equity option markets. We show that this implied funding liquidity measure significantly predicts future excess market returns and explains cross-sectional variations of stock returns. We provide evidence that investing in stocks with the largest exposure to the innovations in implied funding liquidity and shorting stocks with the smallest generate significant returns of about 7.3% per annum. We also observe that implied funding liquidity significantly predicts future changes in a number of macroeconomic variables over a horizon of six months. This result indicates that the funding liquidity measure obtained from the option markets provides forward-looking information about developments in the economy. Furthermore, we also examine the relationship between implied funding liquidity and the cross section of excess returns arising from the carry trades, which are strategies for investing in high interest rate currencies while borrowing in low interest rate currencies. We show that this implied funding liquidity is significantly associated with high interest rate currencies. We also consider the assetpricing implications of the funding liquidity for other asset classes such as hedge funds.