Bond Misallocation and Liquidity Risk
51 Pages Posted: 20 Aug 2020
Date Written: July 17, 2020
Which corporate bond's yield is more exposed to search frictions? Is the exposure correlated with dealers' inter-mediation? We propose a measure of bond's mis-allocation among dealers and show its correlation with bond's liquidity risk which is attributed to search frictions. This measure is defined as the cross-sectional covariance of dealers' private valuations for a bond and their corresponding inventory positions. Using a transaction-level dataset on U.S. corporate bonds, we verify: a higher mis-allocation is associated with a higher magnitude of liquidity risk. A search-match model with dealers' endogenous search efforts offers an explanation on this correlation.
Keywords: corporate bond market, bond mis-allocation, liquidity risk, search frictions
JEL Classification: G10, G12, G20
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