What Determines Bid-Ask Spreads in Over-the-Counter Markets?
48 Pages Posted: 11 Dec 2018
Date Written: November 18, 2018
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: Suggested Citation