Limits to Arbitrage in Sovereign Bonds: Price and Liquidity Discovery in High Frequency Quote Driven Markets

Projekt Start: 07/2014
Status: Beendet
Forscher: Mario Bellia, Loriana Pelizzon, Max Riedel, Marti Subrahmanyam, Davide Tomio, Jun Uno
Kategorie: Financial Markets, Systemic Risk Lab
Finanziert von: LOEWE

Topic and Objectives

The European Sovereign Debt Crisis reached its peak in summer 2011 with the downgrade of two of the major European economies, Spain and Italy. Due to the high interconnectedness between the public and private financial sectors in Europe, the risk of jeopardizing the whole EU economy and also economies beyond was concrete and high. So, the crisis was approached by many policy makers through fiscal action and monetary policy.

In this project, we have examined the dynamic relationship between credit risk and liquidity in the sovereign bond market in the context of the interventions of the European Central Bank (ECB) – LTRO and OMT –, arguing that monetary policy interventions are the most effective to calm the sovereign debt crisis down due to the strong relationship between credit risk and market liquidity.

We base our specific econometric approach on the Italian sovereign bond market utilizing a unique tick-by-tick dataset provided by Mercato dei Titoli di Stato (MTS) and selecting a window of 18 months around the EU sovereign debt crisis. We formulate and empirically test 3 hypotheses:

  1. the relationship between the credit risk of a sovereign bond and its liquidity is statistically significant, non-linear and credit risk driven;
  2. the monetary policy interventions of the ECB affect the dynamics of the relationship between credit risk and market liquidity;
  3. global systemic risk factors, approximated by a set of state variables, may affect market liquidity.

Key Findings

  • Empirical evidence confirms our hypothesis i) in that Italy’s creditworthiness significantly determined market liquidity of sovereign bonds in a non-linear way with a break point set at 500 bp of the CDS spread.
  • Concerning hypothesis ii) we demonstrate the effectiveness of the LTRO program by showing that, after the quantitative ease provided by the ECB, no significant change in the relationship between credit risk and market liquidity was observable despite the CDS spread breached the 500 bp threshold.
  • With respect to hypothesis iii) we find that, among the tested global systemic risk factors, the only state variable affecting market liquidity after the ECB intervention is the global funding liquidity CCBSS. Thus, ECB action not only improved the liquidity of the market but substantially loosened the link between credit risk and market liquidity.

Policy Implications

Our paper provides a relevant indication for policy makers and regulators: the ECB’s LTRO program, with the objective of providing short-term liquidity to banks, has shown that the channel from bank bailout to sovereign risk can also be reversed. Offering liquidity to banks may improve market liquidity of sovereign bonds and, indirectly, reduce sovereign risk.


Zugehörige publizierte Papers

Autor(en) Titel Jahr Forschungs­bereich Keywords
Loriana Pelizzon, Marti Subrahmanyam, Davide Tomio, Jun Uno Sovereign Credit Risk, Liquidity, and ECB Intervention: Deus Ex Machina?
Journal of Financial Economics
2016 Financial Markets, Systemic Risk Lab Liquidity, Credit Risk, Euro-zone Government Bonds, Financial Crisis, MTS Bond Market

Zugehörige Working Papers

Nr. Autor(en) Titel Jahr Forschungs­bereich Keywords
95 Loriana Pelizzon, Marti Subrahmanyam, Davide Tomio, Jun Uno Sovereign Credit Risk, Liquidity, and ECB Intervention: Deus Ex Machina? 2015 Financial Markets, Systemic Risk Lab Liquidity, Credit Risk, Euro-zone Government Bonds, Financial Crisis, MTS Bond Market

 

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