Hostname: page-component-cd9895bd7-mkpzs Total loading time: 0 Render date: 2024-12-25T19:52:21.412Z Has data issue: false hasContentIssue false
  • English
  • Français

Liquidity and Arbitrage in the Market for Credit Risk

Published online by Cambridge University Press:  15 February 2011

Amrut Nashikkar ,
Marti G. Subrahmanyam  and
Sriketan Mahanti
Amrut Nashikkar
Affiliation:
Barclays Capital Inc., 745 7th Ave., New York, NY 10019 and New York University. amrut.nashikkar@barclayscapital.com
Marti G. Subrahmanyam
Affiliation:
Stern School of Business, New York University, 44 W. 4th St., New York, NY 10012. subrahm@stern.nyu.edu
Sriketan Mahanti
Affiliation:
Orissagroup, 1050 Winter St., Ste.1000, Waltham, MA 02451. sriketan@idomail.com
Get access Rights & Permissions [Opens in a new window]

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- and bond-level variables related to credit risk affect the basis, indicating that the CDS spread does not fully capture the credit risk of the bond.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 46 , Issue 3 , June 2011 , pp. 627 - 656
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2011

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Acharya, V. V.; Bharath, S. T.; and Srinivasan, A.. “Does Industry-Wide Distress Affect Defaulted Firms? Evidence from Creditor Recoveries.” Journal of Financial Economics, 85 (2007), 787–821.CrossRefGoogle Scholar
Acharya, V. V., and Pedersen, L. H.. “Asset Pricing with Liquidity Risk.” Journal of Financial Economics, 77 (2005), 375–410.CrossRefGoogle Scholar
Amihud, Y., and Mendelson, H.. “Asset Pricing and the Bid-Ask Spread.” Journal of Financial Economics, 17 (1986), 223–249.CrossRefGoogle Scholar
Amihud, Y.; Mendelson, H.; and Pedersen, L. H.. “Liquidity and Asset Prices.” Foundations and Trends in Finance. Hanover, MA: Now Publishers (2006).Google Scholar
Blanco, R.; Brennan, S.; and Marsh, I. W.. “An Empirical Analysis of the Dynamic Relation between Investment-Grade Bonds and Credit Default Swaps.” Journal of Finance, 60 (2005), 2255–2281.CrossRefGoogle Scholar
Chakravarty, S., and Sarkar, A.. “Liquidity in U.S. Fixed Income Markets: A Comparison of the Bid-Ask Spread in Corporate, Government, and Municipal Bond Markets.” Staff Report of the Federal Reserve Bank of New York, 73 (1999).Google Scholar
Chen, L.; Lesmond, D. A.; and Wei, J.. “Corporate Yield Spreads and Bond Liquidity.” Journal of Finance, 62 (2007), 119–149.CrossRefGoogle Scholar
Duffie, D.. “Special Repo Rates.” Journal of Finance, 51 (1996), 493–526.CrossRefGoogle Scholar
Duffie, D.. “Credit Swap Valuation.” Financial Analysts Journal, 55 (1999), 73–87.CrossRefGoogle Scholar
Duffie, D.; Gârleanu, N.; and Pedersen, L. H.. “Securities Lending, Shorting, and Pricing.” Journal of Financial Economics, 66 (2002), 307–339.CrossRefGoogle Scholar
Elton, E. J.; Gruber, M. J.; Agrawal, D.; and Mann, C.. “Explaining the Rate Spread on Corporate Bonds.” Journal of Finance, 56 (2001), 247–277.CrossRefGoogle Scholar
Eom, Y.; Helwege, J.; and Huang, J.-Z.. “Structural Models of Corporate Bond Pricing: An Empirical Analysis.” Review of Financial Studies, 17 (2004), 499–544.CrossRefGoogle Scholar
Fisher, L.. “Determinants of Risk Premiums on Corporate Bonds.” Journal of Political Economy, 67 (1959), 217–237.CrossRefGoogle Scholar
Grinblatt, M.. “An Analytic Solution for Interest Rate Swap Spreads.” International Review of Finance, 2 (2001), 113–149.CrossRefGoogle Scholar
Hong, G., and Warga, A.. “An Empirical Study of Bond Market Transactions.” Financial Analysts Journal, 56 (2000), 32–46.CrossRefGoogle Scholar
Hotchkiss, E.; Warga, A.; and Jostova, G.. “Determinants of Corporate Bond Trading: A Comprehensive Analysis.” Working Paper, University of Houston, Boston College, and George Washington University (2002).Google Scholar
Houweling, P.; Mentink, A.; and Vorst, T.. “Comparing Possible Proxies of Corporate Bond Liquidity.” Journal of Banking and Finance, 29 (2005), 1331–1358.CrossRefGoogle Scholar
Huang, J., and Huang, M.. “How Much of the Corporate-Treasury Yield Spread Is Due to Credit Risk? A New Calibration.” 14th Annual Conference on Financial Economics and Accounting (FEA); Texas Finance Festival (2003).CrossRefGoogle Scholar
Huang, M.. “Liquidity Shocks and Equilibrium Risk Premia.” Journal of Economic Theory, 109 (2003), 104–129.CrossRefGoogle Scholar
Jankowitsch, R.; Pullirsch, R.; and Veza, T.. “The Delivery Option in Credit Default Swaps.” Journal of Banking and Finance, 32 (2008), 1269–1285.CrossRefGoogle Scholar
J.P. Morgan Securities Inc. “Par Credit Default Swap Spread Approximation from Default Probabilities.” Credit Derivatives (2001).Google Scholar
Longstaff, F. A.; Mithal, S.; and Neis, E.. “Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market.” Journal of Finance, 60 (2005), 2213–2253.CrossRefGoogle Scholar
Mahanti, S.; Nashikkar, A.; Subrahmanyam, M.; Chacko, G.; and Mallik, G.. “Latent Liquidity: A New Measure of Liquidity with an Application to Corporate Bonds.” Journal of Financial Economics, 88 (2008), 272–298.CrossRefGoogle Scholar
Nashikkar, A. J., and Pedersen, L. H.. “Corporate Bond Specialness.” Working Paper, New York University (2007).CrossRefGoogle Scholar
Schultz, P.. “Corporate Bond Trading Costs: A Peek Behind the Curtain.” Journal of Finance, 56 (2001), 677–698.CrossRefGoogle Scholar
Vayanos, D., and Wang, T.. “Search and Endogenous Concentration of Liquidity in Asset Markets.” Journal of Economic Theory, 136 (2007), 66–104.CrossRefGoogle Scholar