International Liquidity CAPM

In this paper we study how funding constraints affect asset prices internationally. We build an equilibrium model with multiple countries where investors face margin constraints, and derive an international funding-liquidity-adjusted CAPM. In particular, the model has implications for (i) the global and local liquidity effect on asset prices in the time series, and (ii) for the pricing of global and local liquidity risk in the cross-section of international assets beyond market risk. To test the model, we construct daily funding liquidity proxies for six different countries and decompose them into one global and six country-specific indices. We then assess whether funding risk is priced in the cross-section of international stock returns. In line with the theoretical predictions, we find that holding betas constant, stocks with higher illiquidity earn higher alphas and Sharpe ratios. A trading strategy that is long high illiquidity to beta ratio stocks and short low illiquidity to beta ratio stocks (BAIL) earns significant positive risk-adjusted returns and outperforms a simple betting-against beta strategy. In the time-series we find that global funding risk is an economically and statistically highly significant predictor of BAIL.