Central Bank-Driven Mispricing

Abstract

We show that the European Central Bank’s bond purchases, undertaken in the context of Quantitative Easing, caused significant mispricing between German and Italian government bonds and their respective futures contracts. We document three channels through which the central bank’s bond purchases led to this mispricing: the deterioration of bond market liquidity, the increased bond “specialness” on the repurchase agreement market, and the higher cost of carry. The mispricing we document is the result of two contemporaneous forces: the increased in trading frictions caused by Quantitative Easing, and regulatory capital constraints that imply non-negative required returns on riskless trades.

Keywords: Central Bank Interventions, Liquidity, Sovereign Bonds, Futures Contracts, Arbitrage

JEL Classification: G01, G12, G14