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Machine learning algorithms Estimation of

liquidity
applied to the estimation of
liquidity: the 10-year United States
treasury bond 341
Ignacio Manuel Luque Raya Received 1 August 2022
Revised 22 January 2023
Universidad de Granada, Granada, Spain, and 8 March 2023
Pablo Luque Raya Accepted 12 March 2023

Credit Suisse Group AG, Zurich, Switzerland

Abstract
Purpose – Having defined liquidity, the aim is to assess the predictive capacity of its representative variables,
so that economic fluctuations may be better understood.
Design/methodology/approach – Conceptual variables that are representative of liquidity will be used to
formulate the predictions. The results of various machine learning models will be compared, leading to some
reflections on the predictive value of the liquidity variables, with a view to defining their selection.
Findings – The predictive capacity of the model was also found to vary depending on the source of the
liquidity, in so far as the data on liquidity within the private sector contributed more than the data on public
sector liquidity to the prediction of economic fluctuations. International liquidity was seen as a more diffuse
concept, and the standardization of its definition could be the focus of future studies. A benchmarking process
was also performed when applying the state-of-the-art machine learning models.
Originality/value – Better understanding of these variables might help us toward a deeper understanding of
the operation of financial markets. Liquidity, one of the key financial market variables, is neither well-defined
nor standardized in the existing literature, which calls for further study. Hence, the novelty of an applied study
employing modern data science techniques can provide a fresh perspective on financial markets.
Keywords Data science, Finance, International markets, Machine learning liquidity, Treasury bond
Paper type Research paper

1. Introduction
The foundation of the present study is the concept of liquidity as a key financial indicator
with which to predict the behavior of financial markets.
Liquidity is the flow of capital and credit within the global financial system. A concept that
both the Bank for International Settlements and the Federal Reserve System apply, as well as
many other financial institutions, as is reflected in the Fed Financial Stability Report. The concept
of liquidity is approached in this study, so as to analyze financial stability, to anticipate systemic
risk and particularly to analyze capital management among certain private sector investors.
The area of greatest economic significance in relation to liquidity is the central banking
community, in which the term “Financial conditions” is also used. This concept is equivalent
to the underlying idea behind liquidity. The capability to anticipate financial instability helps
policymakers to make decisions on monetary policy, and it is likewise decisive for capital
management among certain investors.

© Ignacio Manuel Luque Raya and Pablo Luque Raya. Published in European Journal of Management
European Journal of Management
and Business Economics. Published by Emerald Publishing Limited. This article is published under the and Business Economics
Creative Commons Attribution (CC BY 4.0) licence. Anyone may reproduce, distribute, translate and Vol. 33 No. 3, 2024
pp. 341-365
create derivative works of this article (for both commercial and noncommercial purposes), subject to full Emerald Publishing Limited
attribution to the original publication and authors. The full terms of this licence may be seen at http:// e-ISSN: 2444-8494
p-ISSN: 2444-8451
creativecommons.org/licences/by/4.0/legalcode DOI 10.1108/EJMBE-06-2022-0176
EJMBE Alessi and Detken (2011) used liquidity as a predictive indicator to study asset prices
33,3 during boom/bust cycles that can have serious economic consequences. Chen et al. (2012)
recognized the importance of decision-making and explored the significance of liquidity
for the global economy and for policymakers through multiple sets of liquidity
indicators.
The researchers attempted to model the global financial cycle in terms of the interaction of
monetary policy and financial stability in markets and they emphasized its relevance to
342 central bank interest rate hikes and quantitative easing policies (Miranda-Agrippino and Rey,
2020, May). They also studied the importance of capital inflows and outflows (international
liquidity) to manage the implications of the global financial cycle in emerging markets (Jeanne
and Sandri, 2020). Bernanke et al. (2011) likewise investigated the effects of capital inflows
into the United States on U.S. longer-term interest rates.
The objective that is pursued here is to offer predictions of safe asset prices, through the
application of data science techniques, in particular machine learning, identifying the models
that yield the most promising results. To do so, the 10-year US treasury bond, considered to
be the most representative variable within a typical portfolio of safe assets is used. These
predictions are advanced using certain proxy variables, which are considered representative
of the concept of liquidity. Various machine learning models are compared with stationary
and nonstationary variables.
It is not only that these predictions are of intrinsic value, as they may also serve either to
support or to refute the notion that liquidity fluctuations are in some way responsible for the
fluctuations of other types of assets, specifically the 10-year US treasury bond and, by
extension, economic fluctuations. This can help us to benchmark when working on prediction
exercises with liquidity variables.
The use of machine learning techniques to guide monetary policymaking is a novelty with
growing interest not only from the perspective of central banks themselves but also from the
perspective of academia and, to a lesser extent, independent investors (Guerra et al., 2022).
Despite the widespread use of machine learning, Guerra et al. (2022) reiterated that the
combination of such factors as risk, safe assets, liquidity and the field of artificial intelligence
have rarely been studied together, and in even fewer studies models have been used to
forecast economic flows through liquidity variables, Galindo and Tamayo (2000) and Abell
an
and Castellano (2017) have demonstrated the suitability of machine learning algorithms for
such tasks.
Authors such as Hellwig (2021) defend the improvement in predictions of complex
financial concepts such as liquidity and the different dimensions by which we model it, that
machine learning methods (i.e. random forest or gradient boosted three) attain compared to
other traditional econometric approaches. These improvements in predictions are generally
obtained due to the limits present in the machine learning models when fitting the data which
allow them to explore relationships of variables with a lower risk of overfitting and the
increase in precision that ensemble models tend to achieve by averaging the predictions of
other models.
One practical reason for using the 10-year US bond is its global importance as a
reference price with which many different assets are linked and valued. According to Goda
et al. (2013), long-term Treasury yields are used as a proxy of safe assets and the same
authors also referred to the strong linkages between the Treasury yield and non-Treasury
bond yields.
In summary, the state of the art of the liquidity concept is reviewed in Section 2. The
different machine learning techniques and the theory behind the algorithms are treated in the
same way. Subsequently and arising from that review, a series of research questions
are proposed. In the fourth section, the methodological aspects are explained. In the data
analysis section, the indicators that are common to the different algorithms are presented to
facilitate their analysis, discussion and comparison. Finally, the conclusions that respond to Estimation of
the research questions are set out, indicating the implications for management and for liquidity
investors and institutional decision-making.

2. State of the art

2.1 Liquidity and its different classes
The concept of liquidity has been broadly investigated and discussed, especially since the 343
global financial crisis of 2008. In particular, it has been and continues to be the business and
the concern of the BIS and the IMF. Both financial institutions gather extremely useful
macroeconomic data from reliable sources through surveys administered to central and
commercial banks. The BIS analyzes liquidity from the point of view of financial stability, in
order to minimize systemic risk and vulnerabilities. Its methodology is centered on two basic
variables: banking assets and currency-based credits to the nonfinancial private sector.
Borio et al. (2011) highlighted the ambiguity of the above definition and laid the
foundations of both key concepts to arrive at a standardized definition: separate types of
liquidity, i.e. public or private, and their application within a context of financial stability.
From a macro perspective, they presented the empirical characteristics of the financial cycle
and the implications for monetary policy. In effect, significant movements of liquidity are
associated with systemic banking crises, hence his proposal for the implementation of
mechanisms to anticipate these events, lessening financial distress.
Howell (2020) presented one of the most up-to-date analyses of liquidity. The main ideas
within this field are the classification of liquidity according to the type of source, the cyclic
nature of liquidity, and its implications for financial stability. Its principal contribution
emphasized the shadow banks (institutions not subject to banking regulation) and how they
affect the whole system, especially through collateralized operations and safe assets.
Indicators that seek to capture these operations will be taken into consideration in the
analysis that is completed in this paper.
To Bruno and Shin (2015a, b), the modeling of global credit flows to anticipate financial
distress is the principal example for any study of international liquidity. The works upon
which predictive models are constructed on the basis of banking capital and currency flows
are used to study the transmission of liquidity between different countries.
On the other hand, Stanley Druckenmiller (Barrow, 2017) based his investment strategy
on the analysis of liquidity. “Earnings don’t move the overall market; it’s the Federal Reserve
Board . . . focus on the central banks and focus on the movement of liquidity . . . Most people
in the market are looking for earnings and conventional measures. It’s liquidity that moves
markets”.
Liquidity may be defined as the total quantity of capital and credit existing within the
system for use in the real economy (of products and services) and in the financial markets
(assets). It is a gross financing concept that represents the overall balance of entities
supplying money and credit to the system.
With regard to its source, liquidity may be classified as follows:
(1) Private liquidity or within the private sector (endogenous according to the literature)
covers both financial banking and nonbanking (shadow banks, institutions, large
investors, etc.) sectors, including data on family credit, growth rate in the volume of
financial savings/private credit, and interannual change in consultations of personal
credit and small firms.
(2) Public (or exogenous) liquidity is associated with governmental institutions relating
to the source of official liquidity or the set of tools that the central bank can use,
principally reference interest rates and operations on the open market (asset purchase
EJMBE programs), the monetary base (core of the passive monetary policy of the central
33,3 issuing bank), money in circulation and credits assigned to commercial banks, among
others.
(3) International liquidity or all financial resources available to the monetary authorities
of each country that will be used to finance the deficits in their international balance of
payments when all the other sources supplying foreign funds are insufficient to
344 ensure a balance in international payments.
There is support in the literature for these dimensions of liquidity, particularly Howell (2020).
In it, liquidity was broken down into three sub-components, then explanatory variables were
leveraged to explore each one and finally machine learning modeling was applied to the data.
The same methodology was also applied, although in a different way, in Hatzius et al. (2010),
where the exploratory variables were aggregated and a financial conditions index was
constructed.
Liquidity constitutes a time series, i.e. a set of observations recorded over a particular time
span (Brockwell and Davis, 2009). What is now proposed is the prediction of multivariant time
series, such as metric variables, that measure the different predicted versions within which we
will itemize liquidity based on the ideas discussed in the above-mentioned literature.
The choice of the explanatory variables is endorsed in the literature, and the approach
toward the measurement of liquidity, and the division between public and private sector
entities is based on the work of Landau (2011). He proposed the separation of public and
private factors when analyzing liquidity and the inclusion of both price and balance sheet
quantities. Caruana (2013) also raised the inclusion of stock variables (i.e. amount of debt
outstanding) and flow variables (i.e. bank credit growth) in the analysis of liquidity. Chung
et al. (2014) examined the relationship between financial conditions and the money
aggregates. Shin and Shin (2011) explored the link between monetary aggregates and the
financial cycle.
Lane and McQuade (2014) suggested the inclusion of an international liquidity component,
so as to shed light on financial stability within the domestic financial system. Three
determining factors related to liquidity conditions were described in the work of Eickmeier
et al. (2014): global monetary policy, global credit supply and global credit demand. Finally,
Cesa-Bianchi et al. (2015) utilized bank-to-bank cross-border credit to examine international
liquidity.
Given the above definitions of liquidity, we searched for variables representing different
forms of capital and credit. We then proposed monetary aggregates as variables for capital
and types of loans as variables for credit. The reference interest rate of monetary policy was
used as an explanatory variable, because it is at the most fundamental level the price of
money, it influences liquidity, and the economy, and it is under government control.

2.2 Machine learning

Machine learning models perform iterative processes on a dataset (divided into a training and
a validation or test dataset) that refers to a specific context (in this case, liquidity). On that
basis, predictions of the future values of the dependent variable are advanced (in this case, the
10-year US treasury bond), which are tested and validated with both the training and the
validation datasets. The results are compared with a reference or benchmarked model.
2.2.1 Models with nonstationary variables. Nonstationary variables follow temporal
trends, as they show no constant average or variance over time. In general, the models with
nonstationary variables usually present worse results than the models with stationary
variables. Overfitting affects these models more than the models with stationary variables,
despite applying methods for its reduction that are recommended in the literature.
 Bayesian Ridge Model uses probability distributors rather than point estimates. The Estimation of
output Y is extracted from a probability distribution, instead of its estimation as a unique liquidity
value. In this way, good functioning is guaranteed even with insufficient or poorly
distributed data.
2.2.2 Models with stationary variables. It is far easier to model a stationary than a
nonstationary series. Having transformed nonstationary into stationary variables, the
differences can be compared with the earlier models. That transformation is applied to the
nonstationary variables that are identified with the Augmented Dickey–Fuller tests, 345
operating in the following manner.
If z is a set of differentiated predictions and Y is the value of the original dependent
variable, then
Ytþ1 ¼ Yt þ ztþ1
Ytþ2 ¼ Ytþ1 þ ztþ2 ¼ Yt þ ztþ1 þ ztþ2

The Orthogonal Matching Pursuit (OMP) algorithm, as with other “greedy algorithms”,
constructs a sequential solution X0, X1, X2, . . ., Xk. In this way, it includes an atom that is most
closely correlated with the actual residual at each step and, unlike Matching Pursuit, the
residual is calculated once again after each iteration using an orthogonal projection within the
space of the previously chosen elements. In essence, the algorithm processes all n possibilities
to identify a Column, A, that shows the highest correlation with the observations of y in the
first step (hence the term “matching”), i.e. the best fit of Ax to b. Subsequently, it identifies
Column A in each iteration that shows the highest correlation with the actual residual. It
therefore seeks the atom with the best fit of Ax to b, on the basis of those selected earlier. In
each iteration, the estimation of the vector sign is updated through the most highly correlated
column with Column A (Khosravy et al., 2020). The solution at each step is selected in such a
way that the new residual is “orthogonal” to all the atoms selected in A.
The CatBoost Regressor algorithm is based on the theory behind other algorithms such as
Decision Trees and Gradient Boosting. The principal concept of “boosting” involves
sequential combinations of multiple models that perform slightly better than random chance.
The algorithm is used to create a solid, predictive and competitive model, by applying a
“greedy” search (a mathematical process that tests simple solutions to complex problems,
through the choice of the subsequent step that provides the most obvious benefit).
In the same way as “gradient boosting” adjusts the decision trees in a sequential manner,
the adjusted trees will learn from the errors of the earlier trees and the errors will therefore be
minimized. The process continues until the selected loss function can no longer be minimized.
In the growth process of the decision trees, the algorithm produces “unconscious” trees,
which means that the trees grow, under the rule that all the nodes at the same level test the
same predictor under the same condition. This “unconscious” tree procedure permits simple
adjustments and improves computational efficiency, while the structure of the tree operates
as a means of regularization to identify an optimal solution and to avoid overfitting
(Thiesen, 2020).
The AdaBoost Regressor Model has the objective of fitting a sequence of “weak learners”
(models that are slightly better than a random estimation) to versions of the data that are
repeatedly modified. The predictions of all these “weak learners” are combined through
weighted majority voting, i.e. a sum in which equal account is taken of the weights, in order to
estimate the final predictions.
The data modifications for each “boosting” iteration consist of applying weights w1, w2,
…, wn to each training sample. Initially, all these weights are established through wi 5 1/n,
in such a way that a “weak learner” is trained with the initial data in the first step of the
EJMBE process. The weights of the sample are individually modified for each iteration that is
33,3 successively performed and the algorithm is once again applied to the newly modified data.
According to this method, the weights attached to the observations of the training sample
that are incorrectly predicted are increased, whereas those that are correctly predicted are, on
the contrary, decreased. In doing so, far greater influence is attached to those observations
that the model can only predict with difficulty as the iterations continue. Each subsequent
“weak learner” is therefore obliged to center on the observations that other “weak learners”
346 had mistakenly predicted earlier on (Wang, 2012).
The Extreme Gradient Boosting Model (XGBoost) provides computational rapidity and
performance levels that are difficult to equal. This algorithm functions in the same way as
other models that use the ensemble methods, in which new models are successively generated
from a training set to correct the errors of the earlier models, in a similar way to the above-
mentioned AdaBoost algorithm.
The concept of Gradient Boosting entails the design of new models that predict the
residuals or errors of earlier models, which are then added together to arrive at a final
prediction. It is referred to as Gradient Boosting, because it uses a reduced gradient algorithm
to minimize the loss function when adding new models (Brownlee, 2016a).
Extremely Randomized Trees Model (ET) uses an ensemble decision tree method that
usually yields better results than those based on simple decision trees.
The Extremely Randomized Trees or Extra Trees (ET) algorithm generates a large
number of unpruned decision trees (without removing small-sized branches), based on the
training dataset data, fitting each decision tree to the complete training dataset.
In summary, the principal differences that this algorithm has over other decision tree
ensembles are as follows: the use of the whole training dataset (instead of a bootstrap replica)
to start the growth of the trees as mentioned earlier; the other difference is that ET divides the
nodes, randomly selecting the cutoff points (Geurts et al., 2006). At each cutoff point, the
algorithm activates a random selection of the different features.
The predictions advanced in a regression problem are prepared through the average of all
the decision trees, while a majority voting method among the different decision trees is used
for the classification problems (Geurts et al., 2006). In the case of regression, these averages
are used to improve the predictions and to check for overfitting.
The choice of this algorithm for the completion of the model was due to the problems with
overfitting observed when using the other models, because the random selection of the cutoff
points meant fewer correlations between the decision trees (although this random selection
increased the variance of the algorithm, increasing the number of trees used in the ensemble
can counteract that effect) and the level of overfitting may therefore be reduced in comparison
with the levels of other models.
The Random Forest (RF) algorithm is a decision tree ensemble method similar to ET. Both
are very similar algorithms composed of a large number of decision trees that will influence
the final prediction.
The main differences are, on the one hand, that subsamples generated with the
bootstrapping method are used in Random Forest, i.e. a resampling technique that generates
datasets by continuously repeating the sampling of the available data (James et al., 2013). In
contrast, the overall sample is used in the et algorithm. On the other hand, the cutoff points
were established in the most optimum form in Random Forest, unlike ET in which a higher
randomness component was added to its decision-making.
The above-mentioned greedy algorithms have not been widely discussed in the literature
on similar liquidity problems, so we wish to delve further into their performance in this area of
study. On the other hand, there is ample support for the suitability of both decision tree
algorithms and ensemble methods (Galindo and Tamayo, 2000; Abell
an and Castellano, 2017;
Sahin, 2020), which perform better than conventional approaches and other machine learning
algorithms applied to liquidity-related classification and prediction problems (Guerra Estimation of
et al., 2022). liquidity
2.2.3 Models used with both types of variables. The Voting Model consists of combining
different sorts of automatic learning algorithms and generating final predictions, through an
estimator consensus method (average probabilities when processing a regression problem).
The results are intended to yield separate improvements to the predictions of the original
method. The aim is therefore to improve the predictions of certain individual models through
their combination and by averaging their values. 347

3. Research questions
The importance is evident in both the concept of liquidity and the differentiation of types of
liquidity. A variety of indicators are used to measure the different types. Besides, automatic
learning offers a broad range of possibilities to make predictions, for which reason the general
objective is to predict liquidity through different machine learning algorithms, comparing the
results that are provided, in order to identify the best models. In this case, the price of the 10-
year US treasury bond is taken as a reference and the following research questions are
proposed:
RQ1. Will the estimation of the price of the 10-year US treasury bond with machine
learning models improve upon the estimations of traditional models?
RQ2. Will the best predictions of the 10-year US treasury bond be dependent upon
predictions with either stationary or nonstationary variables?
RQ3. Which machine learning algorithms will yield better estimations of the 10-year US
treasury bond?
RQ4. Which voting models will improve upon the estimations of other models?
RQ5. Which models will present more problems of overlearning in their predictions?
RQ6. Which variables will determine more than any others the price of the 10-year US
treasury bond? Will the private, the public or the international liquidity variables
be the most decisive?

4. Methodological aspects
4.1 Variables and data sources
The dependent variable is the price of the 10-year US treasury bond. It is the most widely
tracked debt indicator and price instrument in the field of financing, being used as a reference
benchmark to calculate different values. It is usually perceived as the “safe” asset by
antonomasia, attracting large quantities of liquidity especially during times of crisis and
uncertainty, in what are referred to as safe havens (Zucchi, 2021).
The contents described in Tables 1–3 were used as the independent variables of private,
public and international liquidity. In Table 1, the variables used to describe money and credit
circulating between private agents are described. In Table 2, the variables used to describe
money and credit circulating between public agents are described and likewise, in Table 3, the
variables used to describe money and credit circulating between international agents are
described.
In Table 4, the variables used to describe different financial markets (bond market, foreign
exchange market, developed economies stock market and emerging economies stock
markets) are described. Quantity and price (market-dependent prices or rates) indicators
are used.
EJMBE Variable Notation in graphs Definition
33,3
Total consumer credit & Total_ConsumerCredit & Total consumer credit in property and
Change in the total Change_Total_ securitized, nonstationary flows
consumer credit ConsumerCredit
Total monetary base (M0) Total_Monetary_Base Total quantity of money (in this case, the US
Dollar) that is in general circulation in the
348 hands of the public or in the form of
commercial banking deposits maintained in
the US central banking reserve (M0)
M1 for the USA M1_USA Monetary aggregate resulting from the sum
of i) money in circulation in USD; ii) private
sector deposits at commercial banks and iii)
other liquid and savings deposits
M2 for the USA M2_USA Monetary aggregate resulting from the sum
of i) M1 aggregate; ii) savings deposits
(<100K) in commercial banks and iii) liquid
funds from the money market
M3 for the USA M3_USA Monetary aggregate resulting from the sum
of i) M2 aggregate and ii) savings deposits
(>100K) in commercial banks
Private credit for the USA Private_Credit_USA Total credit (banking and nonbanking) to the
nonfinancial private sector for the USA
M1 for the EU M1_EU Monetary aggregate resulting from the sum
of i) money in circulation in Euros; ii) private
sector deposits held in commercial banks and
ii) other liquid and savings deposits
M2 for the EU M2_EU Monetary aggregate resulting from the sum
of i) M1 aggregate; ii) savings deposits
(<100K) at commercial banks and iii) liquid
funds from the money market
M3 for the EU M3_EU Monetary aggregate resulting from the sum
of i) M2 aggregate and ii) savings deposits
(>100K) at commercial banks
Private credit for the EU Private_Credit_EU Total credit (banking and nonbanking) to the
Table 1. private sector for the Eurozone
List of variables Note(s): In all cases, on a monthly basis. Data preprocessing converted the quarterly variables into monthly
relating to private figures
liquidity Source(s): Table by authors

Variable Notation in graphs Definition

Bank credit of US Bank_Credit_ Credit in the (asset) balance of US commercial banks

commercial banks Comercial_Banks
Currency in circulation in Currency_in_ Physical amount of money (Dollars) in circulation
the USA Circulation_USA within the monetary system of the USA
Deposits in US commercial Deposits_ Consumer deposits held at US commercial banks
banks Commercial_Banks_
USA
Federal fund rate FEDFUNDS_% The federal fund rate is the reference interest rate for
Table 2. the implementation of monetary policy
List of variables Reference rate of the ECB Reference_Rate_BCE The rate that commercial banks and financial institutions
relating to public (European Central Bank) receive for placing short-term investments with the ECB
liquidity Source(s): Table by authors
4.2 Data preprocessing Estimation of
The data were limited to between January 1, 2000 and December 1, 2020, although 2019 and liquidity
2020 were reserved to make predictions with “unknown” future dates.
Python was used for the processing work. In order to palliate the effect of outliers 2.5% of
the values on each side of the tail of the distribution were removed.
Interpolation was used to standardize the quarterly data on a single monthly timescale. To
do so, the Python programming language was used to establish the date (frequency in
quarters in this case) as the data frame index. We then applied the resample function of the 349
Pandas package to change the frequency to monthly, and we filled in the NA values (or
missing data) obtained through the interpolation function of the same package, using a linear
method. Finally, the data was converted into a column instead of an index format, so that the
data could be merged with the other Pandas DataFrames.
The daily frequency data in the case of the “European Central Bank reference rate”
variable were added in months using the average interest rate of that variable throughout
the month.
It is necessary to analyze the specific characteristics of the series referring to
autocorrelation: seasonality and stationarity (Chhugani, 2020). A moving average was
applied, in order to analyze these tendencies with a temporal window of 12 months, within
which the rolling average was calculated, and exponential softening was also applied, the
results of which are shown in Figure 1.
The US bond, as may be observed, followed a descending trend. The Augmented Dickey–
Fuller test was applied to each variable to test for stationarity. The transformation of the first
difference was applied to the nonstationary variables (the preceding observation was

Notation in
Variable graphs Definition

Global Global_ BIS Indicators of global liquidity. Index composed of two indicators: a)
liquidity Liquidity(%) international banking assets, essentially bank loans throughout the
work, both from other banks and firms and consumers and b) credit to
firms and consumers by denomination of currency (USD, EUR, JPY)
DXY index DXY_Index DXY (US Dollar) index v. a basket of currencies (EURO, YEN, POUND
STERLING, etc.). The DXY is a weighted geometric measure Table 3.
Note(s): Monthly frequency except for the global liquidity indicators that were presented quarterly and were List of variables
preprocessed for the monthly figures relating to
Source(s): Table by authors international liquidity

Variable Notation in graphs Definition

Price of the 10-year Price_Bond_German _10Y 10-year German government bond

German bond
Exchange rate Euro Variation_EU_VS_USD Rate of variation of exchange rate with regard
against Dollar to the US Dollar
Rate of variation of Variation_SP_500 Rate of variation of the US S&P 500 share index
S&P 500 Table 4.
Closing price of the Closing_Price_ Vanguard Emerging Markets Stock Index Fund List of variables
VEIEX VEIEX Investor Shares (VEIEX), monthly prices of the relating to financial
index of emerging economy shares markets used as
Source(s): Table by authors predictors
EJMBE
33,3

350

Figure 1.
Softened exponential of
the dependent variable

subtracted from the current observation over time) converting all the variables that were not
stationary into stationary variables, as shown in Figure 2. Having obtained the predictions of
the model, this transformation was reversed for proper interpretation of the results.

4.3 Modeling
(1) Data selection. The observations from 2019 to 2020 were set aside to make predictions.
Although the extraordinary circumstances of 2020, due to COVID-19, complicated the
predictions, the training dataset extended from January 2000 until December 2011,
while the validation or test dataset extended from January 2012 until December 2018.

Figure 2.
Dickey–Fuller test,
autocorrelation and
partial autocorrelation
of the dependent
variable with
transformation of the
first differences
 (2) Cross-validation strategy. The time series cross-validator, a variation of the k-fold, Estimation of
was used. It returns the first k-folds within the k subsample as a training set and the liquidity
k-fold + 1 as the validation dataset. The successive training datasets are supersets
of the previous datasets. In this way, problems of data leakage and overfitting are
avoided. Data leakage occurs when the data used to train an algorithm hold the
information that the algorithm is attempting to predict (Gutierrez, 2014), in other
words, when the model is trained with data that it is meant to predict and that should
not be available to it. Overfitting occurs when the model memorizes the noise or the 351
random fluctuations in the training data, which implies a negative impact when
generalizing (Brownlee, 2016b). After different tests, it was concluded that the ideal
number of folds was k 5 10.
(3) Normalization. The most widely used option in the literature for the normalization of
temporal series, minmax, was applied.
(4) Multicollinearity. There is no reason for high correlations to affect the model in a
negative way. Although some indications pointed to the liquidity-related variables as
a factor in the price variations of the assets that were considered to be safe, the
predictions were based on correlations rather than causality. Underlying causes
(liquidity) within the financial markets for the variation in the price of safe assets can
be intuitively guessed.
In general, a threshold is established to avoid multicollinearity, according to which if the
correlation between two variables is higher or equal to a particular value, one of them is
removed to minimize problems.
(1) Evaluation of the models. The goodness of the model predictions is usually evaluated
through a comparison with a series of base models (linear regression), rather than
with metrics that are dependent on such scales as the Root Mean Square Error
(RMSE) and the Measure of Absolute Percentage Error (MAPE). It could therefore be
verified that the most complex models contributed greater value to the predictions
than the simpler and more easily interpretable metrics such as MAPE, mentioned
above, and the Mean Absolute Error (MAE).

5. Data analysis
The results were expressed with standard measurement metrics, in order to compare the
different algorithms, following the same evaluation process for each algorithm. The
individual performance of each model is graphically represented for a clearer understanding,
commenting on the differences between the selected metrics, the adjustments of the models
and, in certain cases, the distribution of errors to study the aforementioned adjustments. The
set of results of the models with both stationary and nonstationary variables are summarized
and compared in Table 6.
Two linear regression models were prepared with the previously explained predictors.
Their hyperparameters were adjusted through a Random Grid Search, which was the
benchmark with which other more advanced models were compared. One with nonstationary
variables and another with variables converted into stationary values. Metrics were obtained
from the stationary model that improved upon those of the nonstationary model, as can be
observed in Table 5.
A variety of machine learning models with different regression algorithms were applied.
The R2 statistic, considered of little or no use in the literature (Dunn, 2021) in the context of
prediction-centered automated learning, was not applied. Instead, metrics that were not
EJMBE dependent on the scale were principally used, in this case RMSE. The models whose metrics
33,3 improved upon the pre-established base models may be highlighted.

5.1 Models with nonstationary variables

The Bayesian Ridge Model yielded the best results when using the initial variables:
MAE 5 0.2751, RMSE 5 0.3338 and MAPE 5 0.0783. It was the only one of its type that
352 improved upon the base linear regression model that had been proposed.
This model also improved upon the MSE/RMSE obtained with a persistence model
(MSE 5 0.167, RMSE 5 0.4086) that predicted the price of the 10-year US treasury bond at
tþ1 through the value of t (Figure 3). This particular model therefore contributed value with
respect to the two naı€ve models, thereby ensuring that work with temporal series was not
merely a random walk.
The results of the Voting Model were very similar. They yielded slightly lower results:
MAE 5 0.2781, RMSE 5 0.3386 and MAPE 5 0.0782 (Figure 4). Nonetheless, the overfitting
of these models is easily appreciated.

5.2 Models with stationary variables

The results of the base reference model were improved through the use of various algorithms.
The metrics of the stationary models are shown in detail in Table 6.
The OMP Model is among those that yielded the best results, improving on the base
Linear Regression model and most of the other models (Figure 5). After the changes

MAE RMSE MAPE

Variables Mean SD Mean SD Mean SD
Table 5.
Characteristics of the Nonstationary 0.3451 0.1482 0.4018 0.1615 0.0866 0.0363
linear regression Stationary 0.3116 0.2323 0.3816 0.3816 5.3768 9.4791
models Source(s): Table by authors

Figure 3.
Bayesian Ridge model
applying
nonstationary and
reverse transformation
variables
 Estimation of
liquidity

353

Figure 4.
Comparison of models
applying
nonstationary
variables and reverse
transformation

Model RMSE MAE MAPE Variables Overfitting

Second Voting (OMP/RF/ET) 0.1715 0.1312 1.4816 Stationary No

First Voting (OMP/CatBoost/AdaBoost/ 0.1759 0.1360 1.3781 Stationary Yes
XGBoost)
ET 0.1782 0.1358 1.3479 Stationary No
OMP 0.1786 0.1418 1.558 Stationary No
Random Forest 0.1858 0.1464 1.5869 Stationary No
CatBoost 0.1860 0.1456 1.5149 Stationary Yes
Adaboost 0.1889 0.1499 1.6574 Stationary Yes
XGBoost 0.1899 0.1509 1.4860 Stationary Yes
Voting (BR/RL) 0.3336 0.2781 0.0782 Nonstationary Yes Table 6.
Bayesian Ridge 0.3338 0.2751 0.0783 Nonstationary Yes Metrics obtained by
Stationary Base Linear Regression 0.3816 0.3116 5.3768 Stationary No each model ordered
Non-Stationary Base Linear Regression 0.4018 0.3451 0.0866 Nonstationary No from lowest to
Source(s): Table by authors highest RMSE

introduced to reduce overfitting, the most relevant predictors for the dependent variable were
the interbank interest rate of the US Federal Reserve (FedFunds), the reference interest rate of
the BCE, the price of the German government bond and, finally, the variation of the Euro with
respect to the Dollar.
The CatBoost Model performance was not poor overall, although it was seriously affected
by overfitting, as often happens with “greedy algorithm” based models. Despite having taken
this factor into account and having taken the necessary measures, the R2 values of the
training and the test dataset were 0.934 and 0.501, respectively, which points to a large gap;
the sign of an overfitted model (Figures 6 and 7).
The most important features of the CatBoost model were as follows: M1 monetary
aggregate of both the European Union and the US, the price of the German government bond,
the closing price of VEIEX, the variation of the Euro with respect to the Dollar, the total of the
monetary base, the change of consumer credit, the S&P 500 price and private European
credit.
EJMBE
33,3

354

Figure 5.
OMP model

The most influential independent variables of AdaBoost Model were as follows: the price of
the German government bond (which is the norm for the majority of models), followed by the
M1 monetary aggregate of the European Union, the variable year, the variation of the Euro
with regard to the Dollar, the closing price of the VEIEX, private US and European credit and,
finally, the total monetary base.
When we look at the distribution of the residuals of this model, a certain degree of
overfitting can be seen. The R2 squared of the training dataset was 0.862 while that of the test
dataset was 0.468 (Figure 8).
The metrics obtained with the XGBoost model were as follows: MAE 5 0.1509,
RMSE 5 0.1899 and MAPE 5 1.4860 (Figure 9).
The results of the Feature importance model measured the degree to which one variable
influenced the results based on the predictions of a particular model (Oh, 2019). We can see
 Estimation of
liquidity

355

Figure 6.
CatBoost model

that the most relevant variables were the credit of all commercial banks, the price of the 10-
year German bond and the closing price of the VEIEX. Followed to a lesser degree, but even
so with a notable influence, the variables M1 EU and Total Monetary Base.
The overfitting was high in this model, obtaining an R2 in the training and in the test
datasets of 0.869 and 0.485, respectively.
The ET Model presented very good results, better than those of the base Linear
Regression model and the majority of the other models that were prepared (Figure 10).
With regard to overfitting, the principal reason for the selection of this algorithm was
understood to be somewhat less than in other models that were prepared. The R2 of the
training dataset was 0.613, while the test dataset had an R2 of 0.543, which is an acceptable
difference.
The predictions of this model were principally influenced by the price of the 10-year
German government bond and private credit, both in the EU and in the USA.
EJMBE
33,3

356

Figure 7.
Distribution of
residuals in the
CatBoost model with
stationary variables

The results of the Random Forest Model were somewhat less accurate than the results of ET:
Likewise, the computing time was shorter (Figure 11).
Random Forest presented no overlearning problems, with R2 values for the training and
for the test datasets of 0.583 and 0.517, respectively.
The independent variable which had markedly greater importance when making predictions
for this model was once again the 10-year German bond, followed to a lesser extent by the total
monetary base, the variable FedFunds and private credit both in Europe and the USA.
Two voting models were developed that yielded some of the best results this time with the
stationary variables.
The first model in which OMP–CatBoost–AdaBoost–XGBoost were combined and that
generated new predictions through consensus between estimators (majority voting average
probabilities). The metrics resulting from this combination were very encouraging.
The voting model yielded: MAE 5 0.1360, RMSE 5 0.1759 and MAPE 5 1.3781
(Figure 12).
The second voting model included those models that not only improved the base model
but also presented less overfitting: OMP–Random Forest–Extra Trees.
The metrics of this new model yielded the best results of the study: MAE 5 0.1312,
RMSE 5 0.1715 and MAPE 5 1.4816.
The principal objective of this latter model was to improve the metrics that had previously
been obtained without committing the error of increasing the overfitting. This objective was
satisfactorily achieved through the design of the voting model. The R2 values of the training
and the test datasets were 0.647 and 0.552, respectively, revealing a difference of only 0.095,
which can be attributed to what is known as the generalization gap.

6. Analysis and discussion of the results

According to the results of each algorithm and the metrics with which they are comparable,
we now focus on Table 6, which summarizes the indicators of the models, among which the
 Estimation of
liquidity

357

Figure 8.
AdaBoost model

RMSE may be highlighted to consider the goodness of fit of these models and whether there is
a considerable presence of overfitting in the model.
The low performance of the models with nonstationary variables is evident (in accordance
with the literature), showing problems of overfitting and the worst metrics among all the
models. Only the Bayesian Ridge and the Voting model, prepared with a linear regression
model and the earlier Bayesian Ridge model, managed to overcome the benchmark model
with stationary variables among all the models that were tested.
The machine learning models based on stationary variables presented better RMSE
values, as well as the other metrics under observation.
The CatBoost, AdaBoost and XGBoost models and the first voting model, prepared with
the OMP, CatBoost, AdaBoost and XGBoost models, presented strong overfitting that
represents a major limitation, despite their exceptional results.
On the other hand, the OMP, RF and ET models, and the second voting model (prepared
with those three models) yielded exceptional RMSE values of 0.1786, 0.1858, 0.1782 and
EJMBE
33,3

358

Figure 9.
XGBoost model with
stationary variables

0.1715, respectively. The presence of overfitting in each of these models was disregarded, so it
was concluded that these four machine learning models with stationary variables yielded the
best results. The second voting model with stationary variables was the one that yielded the
best metrics, followed by the ET, the OMP and, finally, the RF models.
It must be noted that some variables were removed from some of the models, either
because they only contributed to background noise or because their removal alleviated
overfitting, helping to determine which variables had been the most important in the
models.
The variable that had the most obvious relevance when predicting the dependent variable
was the price of the 10-year German government bond, as its nature and behavior were very
similar to the dependent variable, with which it showed a very high correlation (0.89). This
correlation points to the presence of multicollinearity, although the value of 0.89 was below
the threshold that is usually employed in the literature of 0.9.
 Estimation of
liquidity

359

Figure 10.
ET model

When testing other models in which this threshold was lower, there were significant losses of
predictive capability. Maintaining the aforementioned variable, which to a great extent
helped to predict the price of the US bond, when considering these circumstances, was
therefore recommendable.
The representative variables of public liquidity had no high impact on the models. Among
the variables of this group, the reference interest rate of the Central European Bank and the
FedFunds (Federal Funds Rate) variables stood out most of all, having a relative relevance in
models such as Random Forest, XGBoost and OMP.
The representative variables of private liquidity were the variables that more than any
others helped the predictions of the different models (second only to the safe assets used as
predictors). The variables of this group that may be highlighted because of their importance
EJMBE
33,3

360

Figure 11.
Random forest model

were principally the M1 monetary aggregate (for Europe and the USA), the M0 monetary
aggregate and the total monetary base (for the USA), closely followed by credit to the private
nonfinancial sector (for Europe and the USA) and, to a lesser extent, the percentile change in
consumer credit.
International liquidity is, outstandingly, the type of liquidity with the vaguest of
definitions and it is especially difficult to measure with precision, consequently, the majority
of its representative variables have been converted into background noise in the models. In
the feature selection step, both the index of global liquidity prepared with BIS indicators and
the DXY indicator of the Dollar versus the basket of currencies (the variables employed as
proxies of international liquidity) were removed from the majority of the models. In general, it
contributed to noise and could have generated overfitting in the models that maintained it.
The price of the 10-year German bond was not the only variable to have substantial
influence on the results of the models. Other variables grouped as safe assets and used as
 Estimation of
liquidity

361

Figure 12.
First voting model

predictors also turned out to be useful for predicting the dependent variable, especially the
variation of the Euro with regard to the Dollar, followed by the closing price of the VEIEX and
to a lesser degree the variation of the S&P 500.

7. Conclusions, recommendations and limitations

On the basis of the above discussion, the following conclusions can now be presented.
The two models that yielded the best results, both in terms of their RMSE and their quality
of fit, were based on decision tree algorithms: the Extra Trees model and the Random Forest
model. There was also one model based on the OMP greedy algorithm. (All three models
employed variables that had been converted into stationary variables following their
transformation into the first difference in the natural log.) These models yielded better results
EJMBE than both the traditional regression base models and the nonstationary variables, as we can
33,3 see in Table 6, thereby responding to research questions Q1 and Q2.
A series of new predictions were generated using a combination of these three best-
performing models in an ensemble (second voting model with stationary variables),
predictions that were better than the other results obtained in this study, with an RMSE of
0.1715. On average, their predictions of 10-year US bond prices over 2019 and 2020 only
deviated 0.1715 from the real price (a deviation expressed in the same units used for the bond);
362 results which are responses to Q3 and Q4.
In line with the theoretical predictions, the models with nonstationary variables presented
clear overfitting as previously mentioned. Regarding the stationary models, those based on
boosting and greedy algorithms presented overlearning in each case, except for the one
running the OMP algorithm. Tree-based models were the best performers in this regard,
especially the ET model, which was specifically selected for this specific reason as supported
by the theory presented in Section 2 (State of the Art).
The second ensemble comprising OMP, ET and Random Forest models showed no
overfitting either, obtaining quality results in that regard. However, the first voting model,
made up of the boosting and greedy algorithm models mentioned above, presented serious
overlearning problems. An expected result, considering that the models with which it was
configured also presented this problem, together with the fact that the voting approach
makes the models more robust, although it can also contribute to increasing the difference
between the proportion of variance explained between the training set and the test set,
thereby contributing to overfitting (Q5).
Likewise, the second voting model presented fewer overlearning problems, while the
nonstationary variables suffered more from this problem (Q5).
In response to Q6, the variables that contributed most to the formulation of the bond price
predictions were the price of the 10-year German government bond, the closing price of the
VEIEX, and the M0 and M1 monetary aggregates. The variables that represent the value of
other assets considered as safe and assets that represent private liquidity have been the most
useful for the preparation of the models. While the public liquidity variables that were defined
contributed to a lower number of models, they nevertheless did so in a significative manner
(FedFunds and reference interest rate of the BCE). In general, they generated inconvenient
levels of noise when training the models, although far less so than the variables of
international liquidity.
Regarding the recommendations derived from the analysis of liquidity metrics, first, the
importance of tracking private liquidity metrics such as banking credit and monetary
aggregates was clear, given that when those indexes descended, clear upward trends of the
price of the US bonds were observed, and vice versa.
Likewise, the tracking of public liquidity, given that there was a strong increase in the
prices of risk assets when they increased in a significative way and vice versa when they fell.
One important fall of the FedFunds predicted future price rises of the S&P 500 index.
Theoretical implications with regard to international liquidity are focused on the need to
develop variables that reflect this category of liquidity more precisely. It is one of the most
difficult challenges for researchers, due to the vast breadth of this conceptual dimension, as
well as its diffuse and mutable definition.
The monitoring of liquidity could facilitate the identification of systemic risks within the
financial system and the consequences of economic activity, as it has already been of
assistance to policymakers. In an earlier initiative, the Federal Reserve of the US (https://
www.boj.or.jp/en/research/brp/fsr/index.htm) and the Bank of Japan (https://www.boj.or.jp/
en/research/brp/fsr/index.htm) began to publish their respective Financial Stability Reports.
The methodology followed by the Federal Reserve of the US for the monitoring of financial
stability may be found in Adrian et al. (2015).
 Our study differs, insofar as it approaches the same concept of liquidity/financial stability Estimation of
from a proactive viewpoint rather than from a reactive one. The predictability of the existing liquidity
forecasting models could be heightened, by selecting liquidity and the corresponding key
variables as the leading indicators for forecasting changes to economic cycles.
The limitations arise from the inclusion of a series of variables of little utility when
advancing predictions on the dependent variable. This increase in the number of futures only
caused overfitting of the model, in particular, in relation to some international and public
liquidity variables. 363
The correlation between US bond and German bond gave rise to problems of
multicollinearity, though it never passed the established threshold in normal use.
Although, they never affected the predictions.
The singular events arise from the interruption of COVID-19 in 2020, adding a major
difficulty to the production of accurate predictions for that year.

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Corresponding author
Ignacio Manuel Luque Raya can be contacted at: [email protected]

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