Sovereign Credit Risk, Liquidity, and ECB Intervention

Journal of Financial Economics, 2016, 122(1),
with Loriana Pelizzon, Marti Subrahmanyam, and Jun Uno.
Featured in Think Tank Review, 2015(23), by the Council of the European Union General Secretariat

We examine the dynamic relationship between credit risk and liquidity in the Italian sovereign bond market during the Euro-zone crisis and the subsequent European Central Bank (ECB) interventions. Credit risk drives the liquidity of the market: a 10% change in the credit default swap (CDS) spread leads to a 13% change in the bid-ask spread, the relationship being stronger when the CDS spread exceeds 500 bp. The Long-Term Re financing Operations (LTRO) of the ECB weakened the sensitivity of market makers’ liquidity provision to credit risk, highlighting the importance of funding liquidity measures as determinants of market liquidity.


Central Bank–Driven Mispricing

Coauthored with Loriana Pelizzon, Marti Subrahmanyam, and Jun Uno.
Featured in Forbes

We show that bond purchases undertaken in the context of quantitative easing efforts by the European Central Bank created a large mispricing between the market for German and Italian government bonds and their respective futures contracts. On top of the direct effect the buying pressure exerted on bond prices, we show three indirect effects through which the scarcity of bonds resulting from the asset purchases drove a wedge between the futures contracts and the underlying bonds: the deterioration of bond market liquidity, the increased bond specialness on the repurchase agreement market, and the greater uncertainty about bond availability as collateral.

Arbitraging Liquidity

This paper shows theoretically and empirically how arbitrage activity contributes to the convergence of liquidity across markets. Based on simple arbitrage arguments, I show theoretically how arbitrageurs’ market and limit orders create a co-movement across markets of bid prices, ask prices, and bid-ask spreads. Empirically, I document how the intensity of arbitrage activity is related to the co-movement of market liquidity between securities linked by arbitrage. I focus on Canadian stocks cross-listed in the United States and also consider commonality across stocks and corporate bonds linked by capital structure arbitrage.

How Sovereign is Sovereign Credit Risk? Global Prices, Local Quantities

Coauthored with Patrick Augustin, Valeri Sokolovski, and Marti Subrahmanyam.

The sovereign default insurance market is concentrated and strongly intermediated, with fluctuations in insurance prices being dominated by common, global sources of risk. Yet, we find that insurance quantities are primarily explained by country-specific factors. Using net positions in sovereign default insurance contracts for 60 countries from October 2008 to September 2015, we find that the stock of a country’s debt, and the size of its economy, explain 75% of cross-country differences in net insured interest. Debt issuance significantly explains variation in its dynamics. Our findings are informative for the regulatory debate on the market for sovereign default insurance.

Limits to Arbitrage in Sovereign Bonds

Coauthored with Loriana Pelizzon, Marti Subrahmanyam, and Jun Uno.

Commonality of liquidity refers to the linkages between liquidity across assets through common market-wide factors, while liquidity discovery refers to the transmission of liquidity between assets linked to each other through arbitrage. This paper investigates the microstructure of the relationship between liquidity discovery, through changes in the quotes posted by market makers and the reactions of arbitrageurs, and price discovery, through the transmission of price shocks between markets. We use data from the cash and futures markets, at the millisecond level, in the context of the Italian sovereign bond markets and find that: (i) even though the futures market leads the cash market in price discovery, the cash market leads the futures market in liquidity discovery, i.e., the willingness of market makers to trade (measured by market depth and bid-ask spread), and (ii) the liquidity in the cash market, and not in the futures market, has a significant impact on the basis between the price of the futures contract and that of the cash bond that is cheapest to deliver.

The Microstructure of the European Sovereign Bond Market

Coauthored with Loriana Pelizzon, Marti Subrahmanyam, and Jun Uno.
Featured in ZeroHedge

We describe the structure of the European Sovereign Bond market and document cross-sectional di fferences in bonds’ liquidity. We present a cohort of classical liquidity measures and relate them to the frequency of quote updates by the market makers.