Dealer liquidity provision and the breakdown of the law of one price: Evidence from the CDS–bond basis

Jaewon Choi; Or Shachar; Sean Seunghun Shin

doi:10.1287/mnsc.2017.3011

Dealer liquidity provision and the breakdown of the law of one price: Evidence from the CDS–bond basis

Jaewon Choi, Or Shachar, Sean Seunghun Shin

Department of Business Administration

Research output: Contribution to journal › Article › peer-review

9 Citations (Scopus)

Abstract

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.

Original language	English
Pages (from-to)	4100-4122
Number of pages	23
Journal	Management Science
Volume	65
Issue number	9
DOIs	https://doi.org/10.1287/mnsc.2017.3011
Publication status	Published - 2019 Sept 1

Bibliographical note

Funding 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.”

Publisher Copyright:
© 2018 INFORMS.

All Science Journal Classification (ASJC) codes

Strategy and Management
Management Science and Operations Research

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Cite this

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title = "Dealer liquidity provision and the breakdown of the law of one price: Evidence from the CDS–bond basis",

abstract = "We examine dealers{\textquoteright} 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.",

author = "Jaewon Choi and Or Shachar and Shin, {Sean Seunghun}",

note = "Funding Information: For helpful comments and discussions, the authors thank Viral Acharya, Patrick Augustin, Jack Bao, Darrell Duffie, Jean-S{\'e}bastien Fontaine, Neil Pearson, Norman Sch{\"u}rhoff, 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 structur{\'e}e et des instruments d{\'e}riv{\'e}s de Montr{\'e}al 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{\textquoteright} 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.” Publisher Copyright: {\textcopyright} 2018 INFORMS.",

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Dealer liquidity provision and the breakdown of the law of one price: Evidence from the CDS–bond basis

Abstract

Bibliographical note

All Science Journal Classification (ASJC) codes

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