Search friction, liquidity risk and bond misallocation

104 Pages Posted: 20 Aug 2020 Last revised: 13 May 2024

See all articles by Shuo Liu

Shuo Liu

Tsinghua University - Tsinghua University School of Economics and Management

Date Written: July 17, 2020

Abstract

Search friction is a key driver of changes in corporate bond yield spreads over time. In the cross-section, the liquidity risk stemming from search friction is significantly priced, and is strongly correlated with the misallocation of bond positions among different traders. I propose a novel measure of bond-specific misallocation, which is the negative covariance between traders’ private valuations and their inventory positions for each bond. I find that bonds with higher levels of misallocation are associated with lower absolute levels of liquidity risk from search friction. I develop a search-and-matching model to explain this correlation.

Keywords: Corporate bond market, Bond misallocation, Liquidity risk, Search frictions

JEL Classification: G10, G12, G21

Suggested Citation

Liu, Shuo, Search friction, liquidity risk and bond misallocation (July 17, 2020). Journal of Financial Markets, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3654674 or http://dx.doi.org/10.2139/ssrn.3654674

Shuo Liu (Contact Author)

Tsinghua University - Tsinghua University School of Economics and Management ( email )

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