Abstract:

We find evidence of a systematic link between U.S. monetary policy conditions and the time-variation in liquidity risk premia around the world. Following a restrictive monetary policy shift by the U.S. Federal Reserve, funding conditions deteriorate, and the returns on higher liquidity risk stocks decline relative to those with lower liquidity risk. This effect is concentrated among stocks in countries in which foreign claims by U.S. banks on local banks and firms are unusually high. A positive, unexpected increase in the Federal Funds futures rate of 10 basis points is associated with an average decline in the liquidity risk premium of 41 basis points. Overall, our results support the claim that liquidity risk premia around the world are dependent on U.S. monetary policy conditions and highlight the importance of a “bank channel” in the transmission of these conditions.