Types of liquidity and limits to arbitrage—the case of credit default swaps

Abstract

we show that funding liquidity (shadow cost of capital for arbitrageurs) as well as asset-specific liquidity (determinants of margin requirements) explain recent deviations in the arbitrage-based parity relationship between the CDS prices and bond yield spreads (CDS-Bond spread basis). Collectively, our analysis corroborates the theory on the determinants of the basis, and suggests that it is important to distinguish between these types of liquidity in determining the circumstances in which relative prices will converge. Median annualized returns for a sample convergence type trading strategy with typical levels of leverage are 80% with a median holding-period of 127 days, but the path to convergence is not smooth.

Evaluating the impact of unconventional monetary policy measures: Empirical evidence from the ECB׳s Securities Markets Programme

“…Inventory effects result from dealers quoting higher yields (lower prices) after having sold off a large position, at which point they are exposed to price risks from an unbalanced can be explained in particular by bond-specific liquidity. For example, Bhanot and Guo (2012) show that in the 2008-09 financial crisis, negative deviations of the CDS-bond basis are explained primarily by funding liquidity and asset-specific market liquidity. DePooter, Martin, and Pruitt (2013) show that the CDS-bond basis corresponds closely to the measure of liquidity premia they derive from a search-based asset pricing model.…”

Regime Switching Determinants of Sovereign CDS Spreads: Evidence From Turkey

“…VIX arises as a measure of event risk (Pan and Singleton, 2008). Through VIX index, one can deduce the investors' sentiments and risk appetites such that as stated by Bhanot and Guo (2012) it can be taken as a proxy for capital availability of hedge fund investors.  vstoxx: The monthly change in the Euro Stoxx 50 Volatility Index (VSTOXX) is used as another indicator of volatility risk premium.…”

The CDS-Bond Basis: Negativity Persistence and Limits to Arbitrage

“…Applying their model to the CDS-bond basis, they conclude that deviations from equilibrium are caused by a difference in margin requirements of funded assets (such as corporate bonds) with respect to their unfunded derivatives (CDS). Bhanot and Guo (2012) examine the role of liquidity as a potential factor of basis deviation from parity.…”