What Determines Bid-Ask Spreads in Over-the-Counter Markets?

48 Pages Posted: 11 Dec 2018

See all articles by Peter Feldhütter

Peter Feldhütter

Copenhagen Business School

Thomas K. Poulsen

BI Norwegian Business School

Date Written: November 18, 2018

Abstract

We document cross-sectional variation in bid-ask spreads in the U.S. corporate bond market and use the variation to test OTC theories of the bid-ask spread. Bid-ask spreads, measured by realized transaction costs, increase with maturity for investment grade but not for speculative grade bonds. For short-maturity bonds, spreads increase with credit risk while long-maturity bonds rated AAA/AA have significantly higher spreads than other investment grade bonds. We find that dealer inventory is the most important determinant of the variation in bid-ask spreads. How bond sales travel through the network of dealers also explains part of the variation, particularly for speculative grade bonds. In contrast, search-and-bargaining frictions and asymmetric information have limited explanatory power.

Keywords: Bid-ask spread, Liquidity, Over-the-counter markets, Inventory costs, Corporate bonds

JEL Classification: C23, G12

Suggested Citation

Feldhütter, Peter and Poulsen, Thomas K., What Determines Bid-Ask Spreads in Over-the-Counter Markets? (November 18, 2018). Available at SSRN: https://ssrn.com/abstract=3286557 or http://dx.doi.org/10.2139/ssrn.3286557

Peter Feldhütter (Contact Author)

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

Thomas K. Poulsen

BI Norwegian Business School ( email )

Nydalsveien 37
Oslo, 0442
Norway

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