How Does Liquidity Affect Government Bond Yields?

The paper explores the determinants of yield differentials between sovereign bonds in the Euro area. There is a common trend in yield differentials, which is correlated with a measure of aggregate risk. In contrast, liquidity differentials display sizeable heterogeneity and no common factor. We propose a simple model with endogenous liquidity demand, where a bond’s liquidity premium depends both on its transaction cost and on investment opportunities. The model predicts that yield differentials should increase in both liquidity and risk, with an interaction term of the opposite sign. Testing these predictions on daily data, we find that the aggregate risk factor is consistently priced, liquidity differentials are priced for a subset of countries, and their interaction with the risk factor is in line with the model’s prediction and crucial to detect their effect.

Liquidity and Asset Prices

We review the theories on how liquidity affects the required returns of capital assets and the empirical studies that test these theories. The theory predicts that both the level of liquidity and liquidity risk are priced, and empirical studies find the effects of liquidity on asset prices to be statistically significant and economically important, controlling for traditional risk measures and asset characteristics. Liquidity-based asset pricing empirically helps explain (1) the cross-section of stock returns, (2) how a reduction in stock liquidity result in a reduction in stock prices and an increase in expected stock returns, (3) the yield differential between on- and off-the-run Treasuries, (4) the yield spreads on corporate bonds, (5) the returns on hedge funds, (6) the valuation of closed-end funds, and (7) the low price of certain hard-to-trade securities relative to more liquid counterparts with identical cash flows, such as restricted stocks or illiquid derivatives. Liquidity can thus play a role in resolving a number of asset pricing puzzles such as the small-firm effect, the equity premium puzzle, and the risk-free rate puzzle.Liquidity; Liquidity Risk; Asset Prices

PhD thesis on liquidity of bond market

This thesis consists of empirical and theoretical studies on the liquidity of bond markets. In the first study, we present an extended model for the estimation of the effective bid-ask spread that improves the existing models and offers a new direction of generalisation. The quoted bid-ask spread represents the prices available at a given time for transactions only up to some relatively small trade size. Trades can be executed inside or outside the quoted bid-ask spread. Thus, we extend Roll's model to include multiple spreads of different sizes and their associated probabilities. The extended model is estimated via a Bayesian approach, and the fit of the model to a time series of a year of corporate bond transaction data is assessed by a Bayesian model selection method. Results show that our extended model fits the data better. Our second study examines the relationships between different liquidity proxies and the non-default corporate yield spread as well as the effective bid-ask spread. We first separate the non-default component of bond spreads from the default one by using the information contained in credit default swaps. We then apply our state-space extension of the Roll model to disentangle the unobservable non-default yield spread from the effective bid-ask spread. The empirical results show that the non-default yield spread has a nonlinear relationship with time to maturity and a positive correlation with the bid-ask spread as well as with the default risk, and therefore may reflect the future expected liquidity. We find that the effective bid-ask spread is related to bond characteristics associated with illiquidity (e.g. timeto-maturity and issue amount) and trading activity measures (e.g. daily turnover, and daily average trade size), indicating that transactions costs are more likely to be associated with the current level of liquidity rather than the future expected liquidity. We also find that the non-default component accounted for a bigger proportion of the yield spread before the financial crisis 2007 - 2009, whereas during the crisis credit risk played a more influential role in determining the yield spread. Common factors such as the underlying volatility and CDS spread explain more of the variation in the non-default yield spread and the bid-ask spread than idiosyncratic factors such as timeto-maturity, issue size, and trading activity proxies do. The third study presents an equilibrium model in which the heterogeneity of liquidity among bonds is determined endogenously. In particular we show that bonds differ in their liquidity despite having identical cash flow, riskiness and issue amount. Under certain conditions, we show that investors have strong preference for concentrating trading on a small number of bonds. We conjecture that the identity of the ones which are traded may result from a `Sunspot' equilibrium where it is optimal for traders to randomly label a subset of the bonds as the `liquid' ones and concentrating trading on them. We also show that changing the model assumptions leads to different equilibrium configurations where trading is spread over the bonds. In addition, by utilising the concepts of stochastic dominance, utility indifference pricing, and some specific assumptions on asset value and order arrival rate, the equilibrium prices and bid-ask spreads can be quantified

Measures of the riskiness of banking organizations: Subordinated debt yields, risk-based capital, and examination ratings

Recently there have been a number of recommendations to increase the role of subordinated debt (SND) in satisfying bank capital requirements as a preferred means to discipline the risk-taking behavior of systemically important banks. One such proposal recommended using SND yield spreads as the triggers for mandatory supervisory action under prompt corrective action guidelines introduced in U.S. banking legislation in the early 1990s. Currently such action is prompted by bank capital ratios. Evidence from previous research suggests that yield information may be a better predictor of bank problems. This paper empirically analyzes potential costs and benefits of using SND signals to trigger prompt corrective action.Risk ; Debt ; Banks and banking ; Bank supervision ; Bank examination

The Indirect Effects of Trading Restrictions: Evidence from a Quasi-Natural Experiment

Stock market trading restrictions directly affect stock prices and liquidity via constraints on investors’ transactions. They also have indirect effects by altering the information environment. We isolate these indirect effects by analyzing the effect of stock market restrictions on the corporate bond market. Using the staggered relaxation of the restrictions on margin trading and short selling in the Chinese stock market as a quasi-natural experiment, we find that the relaxation of these restrictions on a firm’s stock reduces the credit spread of its corporate bond. This effect is more pronounced for firms with more opaque information or lower credit ratings

Time-varying credit risk and liquidity premia in bond and CDS markets

We develop a reduced-form model that allows us to decompose bond spreads and CDS premia into a pure credit risk component, a pure liquidity component, and a component measuring the relation between credit risk and liquidity. CDS liquidity has important consequences for the bond credit risk and liquidity components. Besides the credit risk link, we document a liquidity link between the bond and the CDS market. Liquidity in both markets dries up as credit risk increases, and higher bond market liquidity leads to lower CDS market liquidity. Ignoring CDS liquidity results in partly negative liquidity premia, particularly when CDS liquidity is low. --

Essays on the informational efficiency of credit default swaps

This thesis contributes to the strand of the financial literature on credit derivatives, in particular the credit default swaps (CDS) market. We present four inter-connected studies addressing CDS market efficiency, price discovery, informed trading and the systemic nature of the CDS market. The first study explores a specific channel through which informed traders express their views on the CDS market: mergers and acquisitions (M&A) and divestitures activities. We show that information obtained by major banks while providing these investment services is impounded by CDS rates prior to the operation announcement. The run-up to M&A announcements is characterized by greater predictability of stock returns using past CDS spread data. The second study evaluates the incremental information value of CDS open interest relative to CDS spreads using a large panel database of obligors. We find that open interest helps predict CDS rate changes and stock returns. Positive open interest growth precedes the announcement of negative earnings surprises, consistent with the notion that its predictive ability is linked to the disclosure of material information. The third study measures the impact on CDS market quality of the ban on uncovered sovereign CDS buying imposed by the European Union. Using panel data models and a difference-in-differences analysis, we find that the ban helped stabilize CDS market volatility, but was in general detrimental to overall market quality. Lastly, we investigate the determinants of open interest dynamics to uncover the channels through which CDS may endanger the financial system. Although we find information asymmetry and divergence of opinions on firms’ future performance as relevant drivers of open interest, our results indicate that systematic factors play a much greater influence. The growth of open interest for different obligors co-varies in time and is pro-cyclical. Funding costs and counterparty risk also reduce dealers’ willingness to incur inventory risk; Eficiência dos mercados de Credit Default Swaps Resumo: Esta tese investiga o mercado de derivados de crédito, e em particular o mercado de credit default swaps (CDS). São apresentados quatro estudos interligados abordando temáticas relacionadas com a eficiência informacional, a existência de negociação informada no mercado de CDS, e a natureza sistémica daquele mercado. O primeiro estudo analisa a existência de negociação informada no mercado de CDS antes de operações de aquisição, fusões ou venda de ativos relevantes. A nossa análise mostra uma reação dos prémios de CDS antes do anúncio daqueles eventos, sendo em alguns casos mais imediata do que a reação dos mercados acionistas. O segundo estudo avalia o conteúdo informativo das posições em aberto no mercado de CDS utilizando dados em painel de diferentes empresas ao longo do tempo. Os resultados indiciam que as posições em aberto podem ajudar a prever variações futuras dos prémios de CDS e retornos acionistas. Em acréscimo, verifica-se um aumento estatisticamente significativo das posições em aberto antes da divulgação de surpresas negativas nos resultados das empresas. O terceiro estudo mede os efeitos da proibição de posições longas em CDS sobre entidades soberanas pertencentes ao Espaço Único Europeu sem a detenção do ativo subjacente pelo comprador. A análise mostra um efeito negativo da proibição sobre a qualidade do mercado, pese embora se tenha assistido em simultâneo à redução da volatilidade. Por fim, são analisados os determinantes dos montantes associados a posições em aberto, com o intuito de compreender como o mercado de CDS pode influenciar o risco sistémico. Os resultados indicam que a assimetria de informação e a divergência de opiniões dos investidores influenciam aqueles montantes. Todavia, fatores sistemáticos como risco de contraparte, aversão ao risco e risco de re-financiamento parecem ser ainda mais relevantes por via do efeito que exercem no risco do balanço dos intermediários financeiros

Cross Market Effects of stocks Short-Selling Restrictions: Evidence from the September 2008 Natural Experiment

Using intraday data, this paper investigates empirically the joint stock and corporate bond markets responses to the September 2008 stocks short sell ban. The study intends to exploit the natural experiment in order to asses the impact of the stock market short sale restrictions (stock market liquidity shock) on corporate bond market variables during the nancial crisis period. The short sell ban was one of the levers that regulators pulled in order to manage the financial crisis. The economic question is whether this lever worked or should have been pulled given the complexity of financial market linkages and news dissemination. Recent financial events suggested that, when market conditions are severe, liquidity can rapidly decline or even disappear. Liquidity shocks are the potential channel through which asset prices are influenced by liquidity. However, the standard theoretical equilibrium asset pricing models do not consider trading and thus ignore the time and cost of transforming cash into financial assets and viceversa hence ignoring the impact of the liquidity shocks. Therefore, investigating liquidity shocks empirically, their transmission across markets is of high interest especially during times of high turbulence as we recently witnessed. We use vector autoregression (VAR) approach to model stock and corporate bond returns, volatilities and transaction costs simultaneously, obtaining an econometric reduced form that incorporates causal and feedback effects among the two markets variables. Using VAR tools, we found that shocks in stock market (short sell ban) had a significant negative impact on corporate bond market variables during the time under investigation.

Financial market integration under EMU

The single most important policy-induced innovation in the international financial system since the collapse of the Bretton-Woods regime is the institution of the European Monetary Union. This paper provides an account of how the process of financial integration has promoted financial development in the euro area. It starts by defining financial integration and how to measure it, analyzes the barriers that can prevent it and the effects of their removal on financial markets, and assesses whether the euro area has actually become more integrated. It then explores to which extent these changes in financial markets have influenced the performance of the euro-area economy, that is, its growth and investment, as well as its ability to adjust to shocks and to allow risk-sharing. The paper concludes analyzing further steps that are required to consolidate financial integration and enhance the future stability of financial markets