Dealer Liquidity Provision and the Breakdown of the Law of One Price: Evidence from the CDS-Bond Basis

55 Pages Posted: 18 Mar 2016 Last revised: 27 Jan 2018

See all articles by Jaewon Choi

Jaewon Choi

University of Illinois at Urbana-Champaign - Department of Finance

Or Shachar

Federal Reserve Bank of New York

Sean Seunghun Shin

Aalto University - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: October 21, 2017

Abstract

We examine dealers' liquidity provision against mispricing in the corporate bond market from 2005 to 2009. Dealers on average serve as stabilizing liquidity providers by trading against widening price gaps between corporate bonds and credit default swaps (the CDS-bond basis). However, dealers provide less liquidity as they suffer losses, mispricing becomes wider, or funding situation worsens, consistent with the limited capital capacity of financial intermediaries. We also show that the unwinding of basis arbitrage trading can amplify mispricing by documenting that bond returns following Lehman's collapse were substantially low for bonds with strong pre-existing basis arbitrage activity and for bonds underwritten by Lehman Brothers. Liquidity demand due to the exit of arbitrageurs can be a major driver of disruption in credit markets.

Suggested Citation

Choi, Jaewon and Shachar, Or and Shin, Seunghun, Dealer Liquidity Provision and the Breakdown of the Law of One Price: Evidence from the CDS-Bond Basis (October 21, 2017). Available at SSRN: https://ssrn.com/abstract=2748881 or http://dx.doi.org/10.2139/ssrn.2748881

Jaewon Choi (Contact Author)

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

Or Shachar

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
(212) 720-6974 (Phone)
(212) 720-1582 (Fax)

Seunghun Shin

Aalto University - Department of Finance ( email )

Finland

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