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Liquidity Risk and Correlation Risk: A Clinical Study of the General Motors and Ford Downgrade of May 2005

66 Pages Posted: 5 Mar 2008 Last revised: 29 Sep 2008

Viral V. Acharya

New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance

Stephen M. Schaefer

London Business School - Institute of Finance and Accounting

Yili Zhang

London Business School

Multiple version iconThere are 2 versions of this paper

Date Written: November 18, 2007

Abstract

The GM and Ford downgrade to junk status during May 2005 caused a wide-spread sell-off in their corporate bonds. Using a novel dataset, we document that this sell-off appears to have generated significant liquidity risk for market-makers, as evidenced in the significant imbalance in their quotes towards sales. We also document that simultaneously, there was excess co-movement in the fixed-income securities of all industries, not just in those of auto firms. In particular, using credit-default swaps (CDS) data, we find a substantial increase in the co-movement between innovations in the CDS spreads of GM and Ford and those of firms in all other industries, the increase being greatest during the period surrounding the actual downgrade and reversing sharply thereafter. We show that a measure of liquidity risk faced by corporate bond market-makers - specifically, the imbalance towards sales in the volume and frequency of quotes on GM and Ford bonds - explains a significant portion of this excess co-movement. Additional robustness checks suggest that this relationship between the liquidity risk faced by market-makers and the correlation risk for other securities in which they make markets was likely causal. Overall, the evidence is supportive of theoretical models which imply that funding liquidity risk faced by financial intermediaries is a determinant of market prices during stress times.

Keywords: market liquidity, funding liquidity, excess co-movement, inventory risk, financial crises

JEL Classification: G12, G13, G14, G21, G22

Suggested Citation

Acharya, Viral V. and Schaefer, Stephen M. and Zhang, Yili, Liquidity Risk and Correlation Risk: A Clinical Study of the General Motors and Ford Downgrade of May 2005 (November 18, 2007). Available at SSRN: https://ssrn.com/abstract=1074783 or http://dx.doi.org/10.2139/ssrn.1074783

Viral V. Acharya

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Stephen M. Schaefer

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
+44 171 706 6887 (Phone)
+44 171 724 3317 (Fax)

Yili Zhang (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

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