We examine dealers’ liquidity provision against mispricing in the corporate bond market from 2005 to 2009. Dealers on average serve as stabilizing liquidity providers by trading against widening price gaps between corporate bonds and credit default swaps (the CDS–bond basis). However, dealers cut back on liquidity provision as they suffer losses, mispricing becomes wider, or the funding situation worsens, consistent with the limited capital capacity of financial intermediaries. We also show that the unwinding of basis arbitrage trading can amplify mispricing by documenting that bond returns following the Lehman collapse were very low for bonds with strong preexisting basis arbitrage activity and for bonds underwritten by Lehman Brothers. Liquidity demand due to the exit of arbitrageurs can be a major driver of disruption in credit markets.
Bibliographical noteFunding Information:
For helpful comments and discussions, the authors thank Viral Acharya, Patrick Augustin, Jack Bao, Darrell Duffie, Jean-Sébastien Fontaine, Neil Pearson, Norman Schürhoff, Pierre-Olivier Weill, and Gunther Wuyts; seminar participants at Copenhagen Business School, the Stockholm School of Economics, and the University of Illinois; and conference participants at the South Carolina Fixed Income Conference, the Swiss Winter Conference in Financial Intermediation, 2014 Financial Intermediation Research Society, 2014 Western Finance Association, 2014 European Finance Association, the Institut de la finance structurée et des instruments dérivés de Montréal Conference, and the Central Bank Workshop on the Microstructure of Financial Markets. The authors also thank the Depository Trust and Clearing Corporation (DTCC) for providing the data. The views expressed here are the authors’ and do not necessarily represent the views of the Federal Reserve Bank of New York or of the Federal Reserve System. Earlier versions of this paper were circulated under the title “Did Liquidity Providers Become Liquidity Seekers? Evidence from the CDS-Bond Basis During the 2008 Financial Crisis.”
© 2018 INFORMS.
All Science Journal Classification (ASJC) codes
- Strategy and Management
- Management Science and Operations Research