Dealer Inventory, Pricing, and Liquidity in the OTC Derivatives Markets: Evidence from Index CDSs

Abstract

We examine the effects of dealers’ inventories on the pricing and liquidity of OTC derivatives markets. Using position and pricing data on credit default swap (CDS) indices, we document that the change in index CDS spreads is negatively associated with the change in dealers’ net long positions. The effect of dealer inventory on CDS spreads is stronger after the Volcker Rule is implemented in the United States. Furthermore, the divergence between index CDS spreads and their theoretical values (index basis) is also negatively associated with dealers’ net long positions. Finally, bid-ask spreads and the number of dealers increase when the inventory position of dealers is larger.

Keywords: Inventory, CDS Spread, Liquidity, Index CDS, Dealer, Index Basis, Bid-Ask Spread

JEL Classification: G10, G12, G18, G24