A practical approach to constructing price-based funding liquidity factors

The paper proposes a computationally convenient and parsimonious approach for creating a funding liquidity factor, building on work that relates the lack of funding of financial institutions to their ability to exploit arbitrage opportunities. Fontaine and Garcia (2012) propose a price-based funding liquidity factor from mispricing of bonds of similar characteristics but different ages. However, their arbitrage-free Nelson-Siegel framework requires the use of a non-linear Kalman filter, which is computationally intensive in practice. The novelty of this paper is to suggest an easier method for constructing an alternative liquidity factor that retains much of the same properties. Our proposed method for constructing this proxy liquidity factor relaxes the arbitrage-free assumption in the specification of the term structure model and bases it on a simple and flexible term structure specification. We demonstrate that this parsimonious liquidity factor fits the data well. The constructed factor is highly correlated with the Fontaine and Garcia (2012) liquidity factor and other funding liquidity measures, such as a liquidity factor by Hu et al. (2012), the TED-spread and the CP-spread.