A generally accepted belief about the liquidity risk, among many others, is that its gravity which at other times would remain dormant would suddenly dash into prominence during a crisis. Contrary to such a belief, existing empirical literature fails to show such a behavior. In this paper, we explore the time-series properties of the liquidity risk and its amplification amid the crisis by investigating a unique financial instrument, the Japanese floating-rate note, which can be priced almost by no-arbitrage pricing restrictions alone, thereby providing clean measure of liquidity risk. By using the Bayesian MCMC technique, we estimate the ‘liquidity discount rate’ (LDR hereafter) latent in the notes along with the structural parameters of a liquidity term structure model which introduces a Markovian regime
shifts into the discrete Vasicek model. The time-series behavior of the estimated LDR demonstrates the dramatic vicissitude in market liquidity conditions in accordance with the conventional belief. In addition, we empirically analyze the relationship between the market liquidity and funding liquidity as suggested by Brunnermeier and Pedersen (2009) who theoretically explain the sudden liquidity dry-up during the crisis. We find that in normal times, the market liquidity risk is relatively dormant and it has no systematic relation with the funding liquidity risk. During the crisis, however, the global funding liquidity is shown to drive market liquidity into deterioration. Additionally, as the market for Japanese floating-rate notes did not restore its pre-crisis status, we discuss the plausibility and possibility of the market collapse following the liquidity crisis.
Keywords: Bayesian MCMC, fire sales, funding liquidity, market collapse, liquidity discount rate (LDR)
