Liquidity and Arbitrage in the Market for Credit Risk

by Amrut Nashikkar of New York University & Barclays Capital, Inc.,
Marti G. Subrahmanyam of New York University, and
Sriketan Mahanti of Orissa Group, Inc.

August 15, 2010

Abstract: The recent credit crisis has highlighted the importance of market liquidity and its interaction with the price of credit risk. We investigate this interaction by relating the liquidity of corporate bonds to the basis between the credit default swap (CDS) spread of the issuer and the par-equivalent bond yield spread. The liquidity of a bond is measured using a recently developed measure called latent liquidity, which is defined as the weighted average turnover of funds holding the bond, where the weights are their fractional holdings of the bond. We find that bonds with higher latent liquidity are more expensive relative to their CDS contracts, after controlling for other realized measures of liquidity. Analysis of interaction effects shows that highly illiquid bonds of firms with a greater degree of uncertainty are also expensive, consistent with limits to arbitrage between CDS and bond markets, due to the higher costs of "shorting" illiquid bonds. Additionally, we document the positive effects of liquidity in the CDS market on the CDS-bond basis. We also find that several firm-level and bond-level variables related to credit risk affect the basis, indicating that the CDS spread does not fully capture the credit risk of the bond.

Published in: Journal of Financial and Quantitative Analysis, Vol. 46, No. 3, (June 2011), pp. 627-656.

Previously titled: Limited Arbitrage and Liquidity in the Market for Credit Risk -- and before that -- Latent Liquidity and Corporate Bond Yield Spreads

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