Quoted spreads and trade imbalance dynamics in the European Treasury bond market

Abstract

Using high-frequency transaction data for the three largest European markets (France, Germany and Italy), this paper documents the existence of an asymmetric relationship between market liquidity and trading imbalances: when quoted spreads rise (fall) and liquidity falls (increases) buy (sell) orders tend to prevail. Risk-averse market-makers, with inventory-depletion risk being their main concern, tend to quote wider (narrower) spreads when they think bond appreciation is more (less) likely to occur. It is also found that the probability of being in a specific regime is related to observable bond market characteristics, stock market volatility, macroeconomic releases and liquidity management operations of the monetary authorities.Keywords: Liquidity, trading activity, Treasury bond market, Europe, commonality JEL Classification: G1, G15, C32, C33 -IntroductionOver the past few years a growing body of research has been devoted to analysing the market for government securities in Europe focusing on the dynamic relationship between trading activity and price movements (Cheung et al., 2005) With the aim of contributing to this literature, the present study focuses on the relationship between quoted spreads and trading imbalances and on its financial and macroeconomic determinants. While these issues have been extensively discussed in the case of the US stock market, no comparable analysis has been conducted to date in the case of European markets for government securities.Our analysis is related to the strand of financial literature investigating the interaction between liquidity and trading activity. This interaction affects the process of price discovery (Brandt and Kavajecz, 2004), depends on the degree of financial integration (Hasbrouck and Seppi, 2001;Korajczyk and Sadka, 2008) particular, we document the existence of an asymmetric relationship between quoted spreads and trading imbalances such that when liquidity is high (low) and quoted spreads narrow (wide), sell (buy) orders tend to prevail. For most bonds in the sample, we also find an intermediate state when orders tend to be balanced. Second, after daily averaging intra-day probabilities extracted from the estimated MS-VAR models, we investigate common potential determinants for the switches across states by random effect probit-estimation for longitudinal data. We find that the relationship between liquidity and trading imbalances is affected by financial and macroeconomic factors including: refinancing costs, bond and stock market volatility, changing business and macroeconomic climate and changing monetary policy stance.The rest of the paper is organised as follows. Section 2 presents the data and some descriptive statistics. In Section 3 we investigate the dynamic interaction between quoted spreads and order flow imbalances at the individual bond level. Section 4 explores the role of common factors in explaining co-movements between these two market characteristics at an aggregate level. Section 5 offers some concluding remarks. -Data an...

Expected issuance fees and market liquidity

“…Our findings provide insight on market liquidity and provide an interesting compliment to previous work that has largely focused on the relation between price formation, market liquidity, and trading book imbalances (Menkveld et al, 2004;Caporale et al, 2012), the price discovery process on MTS (Dunne et al, 2007;Caporale and Girardi, 2013), the relation between cost of funds and liquidity (Biais et al, 2004), the overcrowding of liquidity (Coppola et al, 2013), and the impact of informational content of trading activity on bond prices (Alfonso Dufour, 2012). It also lends a different perspective to other studies that operate more from a macro perspective, focusing, for example, on the relation between credit risk and liquidity (Beber et al, 2009;Pelizzon et al, 2016), or volatility and liquidity (Favero et al, 2010) for determining bond yields.…”

Expected Issuance Fees and Market Liquidity

“…Our findings provide insight on market liquidity and provide an interesting compliment to previous work that has largely focused on the relation between price formation, market liquidity, and trading book imbalances (Menkveld et al, 2004;Caporale et al, 2012), the price discovery process on MTS (Dunne et al, 2007;Caporale and Girardi, 2013), the relation between cost of funds and liquidity (Biais et al, 2004), the overcrowding of liquidity (Coppola et al, 2013), and the impact of informational content of trading activity on bond prices (Alfonso Dufour, 2012). It also lends a different perspective to other studies that operate more from a macro perspective, focusing, for example, on the relation between credit risk and liquidity (Beber et al, 2009;Pelizzon et al, 2016), or volatility and liquidity (Favero et al, 2010) for determining bond yields.…”

Price discovery and trade fragmentation in a multi-market environment: Evidence from the MTS system

“…It is naturally related to the expanding literature investigating how the secondary market for eurodenominated securities functions. Previous studies have focused on the dynamic relationship between trading activity and price movements (Cheung et al, 2005) or between yield dynamics and order flow (Menkveld et al, 2004), on the determination of the benchmark [3] status among securities of similar maturity (Dunne et al, 2007), on the analysis of yield differentials between sovereign bonds (Beber et al, 2009), and on whether endogenously determined liquidity and trading activity conditions are driven by common factors for the European market as a whole (Caporale et al, 2012).…”