Finance and Economics Discussion Series (FEDS)
May 2023
The Effects of Volatility on Liquidity in the Treasury Market
Andrew Meldrum, Oleg Sokolinskiy
Abstract:
We study the relationship between volatility and liquidity in the market for on-the-run Treasury securities using a novel framework for quantifying price impact. We show that at times of relatively low volatility, marginal trades that go with the flow of existing trades tend to have a smaller price impact than trades that go against the flow. However, this difference tends to diminish at times of high volatility, indicating that the perceived information content of going against the flow is less when volatility is high. We also show that market participants executing trades aggressively using market orders will experience larger increases in price impact than those executing trades passively using limit orders as volatility increases. And times of low market depth are associated with increased risk of high price impact and high sensitivity to volatility in future, perhaps because liquidity is more reliant on high-speed quote replenishment and is therefore more fragile.
Keywords: liquidity, Treasury market, market depth, volatility, order execution, hidden Markov model
DOI: https://doi.org/10.17016/FEDS.2023.028
PDF: Full Paper
Related Materials: Accessible materials (.zip)
Disclaimer: The economic research that is linked from this page represents the views of the authors and does not indicate concurrence either by other members of the Board's staff or by the Board of Governors. The economic research and their conclusions are often preliminary and are circulated to stimulate discussion and critical comment. The Board values having a staff that conducts research on a wide range of economic topics and that explores a diverse array of perspectives on those topics. The resulting conversations in academia, the economic policy community, and the broader public are important to sharpening our collective thinking.