Hostname: page-component-cd9895bd7-gbm5v Total loading time: 0 Render date: 2024-12-25T08:02:13.613Z Has data issue: false hasContentIssue false
  • English
  • Français

Market Liquidity in a Natural Experiment: Evidence from CDS Standard Coupons

Published online by Cambridge University Press:  01 March 2024

Xinjie Wang Open the ORCID record for Xinjie Wang [Opens in a new window] ,
Ge Wu  and
Zhaodong (Ken) Zhong
Xinjie Wang*
Affiliation:
Department of Finance, Business School, Southern University of Science and Technology
Ge Wu
Affiliation:
Robins School of Business, University of Richmond gwu@richmond.edu
Zhaodong (Ken) Zhong
Affiliation:
Department of Finance and Economics, Rutgers Business School, Rutgers University zdzhong@business.rutgers.edu
*
xinjie.wang@sustech.edu.cn (corresponding author)
Rights & Permissions [Opens in a new window]

Abstract

Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the ‘Save PDF’ action button.

The credit default swap (CDS) Big Bang introduced 2 standard coupons for CDS trading. We exploit the setting of the 2 standard coupons as a natural experiment to quantify the components of the bid–ask spreads in over-the-counter markets. We find that a significant portion of the difference in the bid–ask spread between the 2 coupons is explained by the difference in funding costs. Furthermore, search intensity also explains the variation in the difference in bid–ask spread. The liquidity typically concentrates on one of the standard coupons and can suddenly switch to the other coupon. Using the sudden switch of the primary coupon, we provide further evidence to support the predictions of search-based liquidity models.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , First View , pp. 1 - 27
Copyright
© The Author(s), 2024. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We are grateful for the valuable comments from an anonymous referee, Raymond Fishe, Esen Onur, George Pennacchi (the editor), Julia Reynolds (discussant), Michel Robe, and Hongjun Yan as well as from conference or seminar participants of the 2022 Financial Management Association Annual Meeting and Commodity Futures Trading Commission. Wang acknowledges financial support from the National Natural Science Foundation of China (Project No. 72171107), Southern University of Science and Technology (Grant No. Y01246110), and Shenzhen Stability Support Program Project (Project No. 20231121095510002).

References

Acharya, V. V.; Schaefer, S. M.; and Zhang, Y.. “Liquidity Risk and Correlation Risk: A Clinical Study of the General Motors and Ford Downgrade of 2005.” Quarterly Journal of Finance, 5 (2015), 1–51.CrossRefGoogle Scholar
Amihud, Y., and Mendelson, H.. “Dealership Market: Market-Making with Inventory.” Journal of Financial Economics, 8 (1980), 31–53.CrossRefGoogle Scholar
Andersen, L.; Duffie, D.; and Song, Y.. “Funding Value Adjustments.” Journal of Finance, 74 (2019), 145–192.CrossRefGoogle Scholar
Aragon, G. O., and Strahan, P. E.. “Hedge Funds as Liquidity Providers: Evidence from the Lehman Bankruptcy.” Journal of Financial Economics, 103 (2012), 570–587.CrossRefGoogle Scholar
Basak, S., and Croitoru, B.. “Equilibrium Mispricing in a Capital Market with Portfolio Constraints.” Review of Financial Studies, 13 (2000), 715–748.CrossRefGoogle Scholar
Bongaerts, D.; De Jong, F.; and Driessen, J.. “Derivative Pricing with Liquidity Risk: Theory and Evidence from the Credit Default Swap Market.” Journal of Finance, 66 (2011), 203–240.CrossRefGoogle Scholar
Brunnermeier, M. K., and Pedersen, L. H.. “Market Liquidity and Funding Liquidity.” Review of Financial Studies, 22 (2009), 2201–2238.CrossRefGoogle Scholar
Brunnermeier, M. K., and Sannikov, Y.. “A Macroeconomic Model with a Financial Sector.” American Economic Review, 104 (2014), 379–421.CrossRefGoogle Scholar
Chen, R. R.; Fabozzi, F. J.; and Sverdlove, R.. “Corporate Credit Default Swap Liquidity and its Implications for Corporate Bond Spreads.” Journal of Fixed Income, 20 (2010), 31–57.CrossRefGoogle Scholar
Duffie, D.; Garleanu, N.; and Pedersen, L. H.. “Over-the-Counter Markets.” Econometrica 73 (2005), 1815–1847.CrossRefGoogle Scholar
Glosten, L. R., and Harris, L. E.. “Estimating the Components of the Bid/Ask Spread.” Journal of Financial Economics, 21 (1988), 123–142.CrossRefGoogle Scholar
Glosten, L. R., and Milgrom, P. R.. “Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders.” Journal of financial Economics, 14 (1985), 71–100.CrossRefGoogle Scholar
Gromb, D., and Vayanos, D.. “Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs.” Journal of Financial Economics, 66 (2002), 361–407.CrossRefGoogle Scholar
Grossman, S. J., and Miller, M. H.. “Liquidity and Market Structure.” Journal of Finance, 43 (1988), 617–633.CrossRefGoogle Scholar
He, Z., and Krishnamurthy, A.. “Intermediary Asset Pricing.” American Economic Review, 103 (2013), 732–770.CrossRefGoogle Scholar
Ho, T., and Stoll, H. R.. “Optimal Dealer Pricing Under Transaction and Return Uncertainty.” Journal of Financial Economics, 9 (1981), 47–73.CrossRefGoogle Scholar
Huang, R. D., and Stoll, H. R.. “The Components of the Bid–Ask Spread: A General Approach.” Review of Financial Studies, 10 (1997), 995–1034.CrossRefGoogle Scholar
Junge, B., and Trolle, A.. “Liquidity Risk in Credit Default Swap Markets.” Swiss Finance Institute Research Paper No. 13-65 (2015).Google Scholar
Kitwiwattanachai, C., and Pearson, N. D.. “The Illiquidity of CDS Market: Evidence from Index Inclusion.” Working Paper, University of Connecticut (2014).CrossRefGoogle Scholar
Kyle, A. S. “Continuous Auctions and Insider Trading.” Econometrica, 53 (1985), 1315–35.CrossRefGoogle Scholar
Kyle, A. S., and Xiong, W.. “Contagion as a Wealth Effect.” Journal of Finance, 56 (2001), 1401–1440.CrossRefGoogle 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
Mitchell, M.; Pedersen, L. H.; and Pulvino, T.. “Slow Moving Capital.” American Economic Review, 97 (2007), 215–220.CrossRefGoogle Scholar
Mitchell, M., and Pulvino, T.. “Arbitrage Crashes and the Speed of Capital.” Journal of Financial Economics, 104 (2012), 469–490.CrossRefGoogle Scholar
Qiu, J., and Yu, F.. “Endogenous Liquidity in Credit Derivatives.” Journal of Financial Economics, 103 (2012), 611–631.CrossRefGoogle Scholar
Shleifer, A., and Vishny, R. W.. “The Limits of Arbitrage.” Journal of Finance, 52 (1997), 35–55.CrossRefGoogle Scholar
Siriwardane, E. N. “Limited Investment Capital and Credit Spreads.” Journal of Finance, 74 (2019), 2303–2347.CrossRefGoogle Scholar
Tang, D. Y., and Yan, H.. “Liquidity and Credit Default Swap Spreads.” Working Paper, University of Hong Kong (2007).CrossRefGoogle Scholar
Vayanos, D., and Weill, P. O.. “A Search-Based Theory of the On-the-Run Phenomenon.” Journal of Finance, 63 (2008), 1361–1398.CrossRefGoogle Scholar
Wang, X.; Wu, Y.; Yan, H.; and Zhong, Z. K.. “Funding Liquidity Shocks in a Quasi-Experiment: Evidence from the CDS Big Bang.” Journal of Financial Economics, 139 (2021), 545–560.CrossRefGoogle Scholar
Xiong, W. “Convergence Trading with Wealth Effects: An Amplification Mechanism in Financial Markets.” Journal of Financial Economics, 62 (2001), 247–292.CrossRefGoogle Scholar