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

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

The global financial crisis and the Euro crisis have shown that arbitrage can break down highlighting the fragility of the financial system. A proper understanding of when and why arbitrage breaks down is therefore fundamental, especially in the most liquid markets as sovereign bonds markets.

The objective of this research project is to understand (i) the linkage between cash and futures markets, (ii) the effect of a decline in liquidity in either market on the cash-futures relationship, (iii) the influence of a decline in the liquidity in one market on the other, and (iv) the impact of ECB interventions on the linkage between these two markets in terms of price and liquidity, all in the context of sovereign bonds.

We plan to focus our empirical analysis on two major European sovereign cash bond and futures markets that were prominent during the Euro-zone crisis: France and Italy.

The data we use in this study is obtained from diverse sources. The data for the cash sovereign bonds are obtained from the MTS Group. This new and unique dataset consists of detailed quote, order and transaction data for all European Sovereign Bonds. We focus on Italian and French sovereign bonds. The bond futures data, obtained from Reuters, encompass all trades and quotes for futures contracts on long-term coupon-bearing bonds on Eurex. Both datasets are stamped at the millisecond level and allow for the analysis of the dynamics of the high-frequency interaction between the two markets that are linked by arbitrage.

The price of a futures contract is established in relation to the underlying deliverable cash bonds by an arbitrage condition, so that when the two prices diverge, arbitrageurs profit from taking a long position in the cheaper security and a short position in the more expensive security, thus locking in a riskless return. When a shock, whether due to information or liquidity, hits either the cash or the futures market, arbitrageurs will profit from it, if there is a divergence between prices in the two markets.

The determination of which market reveals the new information first and, consequently, which market adjusts accordingly, resulting in price discovery, is a question that can only be answered empirically. At the same time, the answer will possibly depend on the observation frequency that is selected for the analysis: the higher the frequency, the greater the likelihood of a discrepancy.

We also investigate whether ECB interventions in the cash market, directly through the Securities Markets Programme (SMP) and Outright Monetary Transactions (OMT), and indirectly, through the Long-Term Refinancing Operation (LTRO), had potentially perverse effects on the limits to arbitrage between these two markets, and hence, on their liquidity.

The acquisition of data is done but the researchers are still in touch with MTS and Deutche Börse for updating the data. A working paper that has inspired this project: “Sovereign Credit Risk, Liquidity, and ECB Intervention: Deus ex Machina?” is being revised for resubmission at the Journal of Financial Economics. The second is a working paper in progress and has been presented at the ECB conference on “Non-standard monetary policy measures” among others.

 

Zugehörige publizierte Papers

Forscher/innenTitelJahrProgrammbereichKeywords
Loriana Pelizzon, Marti Subrahmanyam, Davide Tomio, Jun UnoSovereign 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.Forscher/innenTitelJahrProgrammbereichKeywords
95Loriana Pelizzon, Marti Subrahmanyam, Davide Tomio, Jun UnoSovereign 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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