A Market-Based Funding Liquidity Measure

In this paper, we construct a traded funding liquidity measure from stock returns. Using a stylized model, we show that the expected return of a beta-neutral portfolio, which exploits investors' borrowing constraints (Black (1972)), depends on both the market-wide funding liquidity and stocks' margin requirements. We extract the funding liquidity shock as the return spread between two beta-neutral portfolios constructed using stocks with high and low margin. Our return-based measure is correlated with other funding liquidity proxies derived from various markets. It delivers a positive risk premium, which cannot be explained by existing risk factors. Positive correlation also exists between the funding liquidity measure and market liquidity measures. Using our measure, we find that while hedge funds in general are inversely affected by funding liquidity shocks, some funds exhibit funding liquidity management skill and thus earn higher returns.