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.


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.

Why Do Investors Buy Sovereign Default Insurance?

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

We provide empirical evidence for a significant complementarity between the size of a country’s debt and the net amount of insurance purchased against government default, using a novel data set of net notional amounts outstanding for single-name sovereign credit default swaps (CDS) from October 2008 to September 2015. Domestic and international debt, the underlying reference obligation for emerging market contracts, reflect different information and, together with the size of the economy, explain up to 75% of the cross-country variation in net insured positions. Unlike for CDS spreads, for which a single principal component accounts for 54 percent of the variation, common global factors explain only up to 7 percent of the variation in sovereign CDS net notional amounts outstanding, consistent with findings that net sovereign insurance is driven primarily by country-specific risk. We further pinpoint two economic channels that explain the net trading in sovereign CDS: (a) country-specific credit risk shocks that change banks’ capital requirements based on regulatory rating thresholds, and (b) the issuance, but not the announcement, of domestic and international debt. All our findings suggest a strong hedging motive for the use of sovereign CDS.

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.