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Nathaniel Frank is with the Oxford –Man Institute of Quantitative Finance and Nuffield College, University of Oxford, and Heiko Hesse with the IMF. We thank Laura Kodres, Kevin Sheppard, and Brenda Gonzalez-Hermosillo as well as conference participants at the Banque de France and Brunel University and seminar participants at Bates College, the Bundesbank, Catholic University in Rio de Janeiro, Chinese Academy of Social Sciences, Chinese University of Hong Kong, IMF and Oxford for suggestions and comments. Oksana Khadarina provided excellent research assistance.
The SIVs or conduits were funded through the issuance of short-term asset-backed commercial paper (ABCP) in order to take advantage of a yield differential resulting in a maturity mismatch.
The former is based on a prudency motive whereby banks hoarded liquid assets in order to insure themselves against contingent liabilities. In contrast, the latter was due to uncertainty with regard to the mortgage exposure of counterparties and the inability to value their respective assets.
This indicated that despite the higher supply of US Treasuries, market participants had very high demand for US Treasury collateral and were very concerned about counterparty risk, even though governments had implemented a systematic response by re-capitalizing major financial institutions and guaranteeing liabilities of banks.
The bankruptcy of Lehman Brothers saw the gold price soar over 20% within a few weeks, as global risk appetite dramatically deteriorated and precipitated a run for quality across asset classes and markets.
Humps occur at the time of the Bear Stearns rescue by JP Morgan in March 2008, during the Fannie and Freddy bailout by the U.S. government in mid-July 2008 and around the time of Lehman’ bankruptcy.
Funding liquidity refers to the availability of funds such that a solvent agent is able to borrow in the market in order to service his obligations.
After the Lehman Brothers collapse, we use the average CDS values for Goldman Sachs, Merrill Lynch and Morgan Stanley for the Lehman Brothers time series data.
Note also that market-traded prices such as CDS spreads contain a liquidity risk component—the risk that an investor may or may not be able to trade at a price close to the last traded price.Such risks rise during periods of stress.
Given the high volatility movements during the recent financial crisis, the assumption of constant conditional correlation among the variables in the CCC model is not very realistic especially in times of stress where correlations can rapidly change. Therefore, the DCC model is a better choice since correlations are time-varying.