Liquidity and Arbitrage in the Market for Credit Risk

Abstract

The recent credit crisis has highlighted the importance of market liquidity and its interaction with the price of credit risk. We investigate this interaction by relating the liquidity of corporate bonds to the basis between the credit default swap (CDS) spread of the issuer and the par-equivalent bond yield spread. The liquidity of a bond is measured using a recently developed measure called latent liquidity, which is defined as the weighted average turnover of funds holding the bond, where the weights are their fractional holdings of the bond. We find that bonds with higher latent liquidity are more expensive relative to their CDS contracts, after controlling for other realized measures of liquidity. Analysis of interaction effects shows that highly illiquid bonds of firms with a greater degree of uncertainty are also expensive, consistent with limits to arbitrage between CDS and bond markets, due to the higher costs of "shorting" illiquid bonds. Additionally, we document the positive effects of liquidity in the CDS market on the CDS-bond basis. We also find that several firm-level and bond-level variables related

Determinantes do Bond Spread e do Credit Default Swap: Por que são diferentes? O caso da Petrobras

“…This option, named as cheapest-to-deliver option (CTD), would tend to make the CDS price rise, increasing the basis. Although difficult to measure, this option has great explanatory power in relation to the CDS value or the difference between the two securities, as noticed by Blanco et al (2005), De Wit (2006, Ammer and Cai (2007), Saltuk (2009), Nashikkar, Subrahmanyam andMahanti (2011), and Bai and Collin--Dufresne (2013). Just as in our study, Zhu (2004) assigns little value to this option.…”

Can Islamic injunctions indemnify the structural flaws of securitized debt?

“…This is a serious problem often overlooked. Illiquidity affects prices of the debt instruments (Nashikkar et al 2011) and results in increased bid-ask spread (Bao, et al 2011). Liquidity dry ups causes defaults within the financial system, affects growth of financial markets, and may even result in financial market crashes (Dick-Nielsen et al 2012;Friewald et al, 2012).…”

Market frictions and the pricing of sovereign credit default swaps

“…A non-exhaustive review of this literature includes the papers by Longstaff et al (2005), Tang and Yan (2008), Bongaerts, Jong and Driessen (2011), Nashikkar, Subrahmanyam andMahanti (2011) or Corò, Dufour andVarotto (2013), among others. Earlier studies in this field argued that CDS prices may not be significantly affected by liquidity because their specific contractual nature makes it possible to easily trade large notional amounts compared to bond markets; see, for instance, Longstaff et al (2005) and Blanco, Brennan and Marsh (2005).…”