Sovereign Credit Risk, Liquidity, and ECB Intervention: Deus Ex Machina?

SAFE Working Paper No. 95

66 Pages Posted: 1 Apr 2015

See all articles by Loriana Pelizzon

Loriana Pelizzon

Goethe University Frankfurt - Faculty of Economics and Business Administration; Goethe University Frankfurt - Research Center SAFE; Ca Foscari University of Venice

Marti G. Subrahmanyam

New York University - Stern School of Business

Davide Tomio

Darden School of Business

Jun Uno

Waseda University

Date Written: March 2015

Abstract

This paper examines the dynamic relationship between credit risk and liquidity in the sovereign bond market in the context of the European Central Bank (ECB) interventions. Using a comprehensive set of liquidity measures obtained from a detailed, quote-level dataset of the largest interdealer market for Italian government bonds, we show that changes in credit risk, as measured by the Italian sovereign credit default swap (CDS) spread, generally drive the liquidity of the market: a 10% change in the CDS spread leads a 11% change in the bid-ask spread. This relationship is stronger, and the transmission is faster, when the CDS spread is above the 500 basis point threshold, estimated endogenously, and can be ascribed to changes in margins and collateral, as well as clientele effects. Moreover, we show that the Long-Term Refinancing Operations (LTRO) intervention by the ECB weakened the sensitivity of the liquidity provision by the market makers to changes in the Italian government's credit risk. We also document the importance of market-wide and dealer-specific funding liquidity measures in determining the market liquidity for Italian government bonds.

Keywords: Liquidity, Credit Risk, Euro-zone Government Bonds, Financial Crisis, MTS Bond Market

JEL Classification: G01, G12, G14

Suggested Citation

Pelizzon, Loriana and Subrahmanyam, Marti G. and Tomio, Davide and Uno, Jun, Sovereign Credit Risk, Liquidity, and ECB Intervention: Deus Ex Machina? (March 2015). SAFE Working Paper No. 95. Available at SSRN: https://ssrn.com/abstract=2587786 or http://dx.doi.org/10.2139/ssrn.2587786

Loriana Pelizzon (Contact Author)

Goethe University Frankfurt - Faculty of Economics and Business Administration ( email )

Theodor-W.-Adorno-Platz 3
Frankfurt am Main, D-60323
Germany

Goethe University Frankfurt - Research Center SAFE ( email )

Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

HOME PAGE: http://www.safe-frankfurt.de

Ca Foscari University of Venice ( email )

Dorsoduro 3246
Venice, Veneto 30123
Italy

Marti G. Subrahmanyam

New York University - Stern School of Business ( email )

Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)

Davide Tomio

Darden School of Business ( email )

100 Darden Boulevard
Charlottesville, VA 22903
United States

Jun Uno

Waseda University ( email )

1-6-1 Nishi-Waseda
Shinjuku-ku
Tokyo, 1698050
Japan

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