A practical approach to constructing price-based funding liquidity factors

The paper proposes a computationally convenient and parsimonious approach for creating a price-based funding liquidity factor, building on work that relates the lack of funding of financial institutions to their ability to exploit arbitrage opportunities. By studying mispricing among bonds of similar characteristics but of different ages, Fontaine and Garcia (2012) use an arbitrage-free Nelson-Siegel framework to construct a price-based liquidity factor. However, this requires the use of a non-linear Kalman filter, which is computationally intensive in practice. We construct an alternative liquidity factor estimate by relaxing the arbitrage-free assumption in the specification of the term structure model and basing 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.