Staff Reports
Liquidity, Volatility and Flights to Safety in the U.S. Treasury Market: Evidence From A New Class of Dynamic Order Book Models
December 2012  Number 590
JEL classification: C58, G01, G12

Authors: Robert F. Engle, Michael J. Fleming, Eric Ghysels, and Giang Nguyen

We propose a new class of dynamic order book models that allow us to 1) study episodes of extreme low liquidity and 2) unite liquidity and volatility in one framework through which their joint dynamics can be examined. Liquidity and volatility in the U.S. Treasury securities market are analyzed around the time of economic announcements, throughout the recent financial crisis, and during flight-to-safety episodes. We document that Treasury market depth declines sharply during the crisis, accompanied by increased price volatility, but that trading activity seems unaffected until after the Lehman Brothers bankruptcy. Our models' key finding is that price volatility and depth at the best bid and ask prices exhibit a negative feedback relationship and that each becomes more persistent during the crisis. Lastly, we characterize the Treasury market during flights to safety as having much lower market depth, along with higher trading volume and greater price uncertainty.
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