Three essays on liquidity in the fixed-income markets
My dissertation looks at the liquidity issues in the fixed-income markets during the recent subprime crisis. It contains three chapters.
The recent crisis has resulted in many observed deviations in relative asset price. The first two chapters study how liquidity crisis affects the relative asset pricing in the fixed-income market. Chapter 1 looks at two relative assets, Credit default swap (CDS) and its corresponding reference corporate bond, and I observe huge negative deviations in the arbitrage based parity relationship between CDS price and corresponding corporate bond yield spreads for the period 6/2008 to 9/2009. And Chapter 2 examines credit spreads between corporate bond yields and treasury bond yields. I found some instance of negative credit spreads during the financial crisis. However, all those observations in these two chapters are not consistent with the arbitrage-based pricing theory and, therefore, have drawn the attention of policy makers and market participants alike. In those two chapters I propose that arbitrage trading is also risky and constraint. In particular, I focus on the types of liquidity- funding and asset specific liquidity- and their role in determining relative asset prices. I provide the empirical evidence that the observation of arbitrage mispricing between two relative assets in the credit risk market can be explained by the funding liquidity constraints and asset specific liquidity constraints during the recent financial crisis period. Collectively my analysis contributes to a recent debate regarding the impact of liquidity on relative asset prices.
Chapter 3 investigates the impact of parameter uncertainty on corporate bond liquidity before and after the onset of the recent crisis. Using monthly corporate bond data for the period 2005 to 2010, firm level parameters implied by a structural model of corporate debt are used to construct proxies for parameter uncertainty. I find that uncertainty about firm parameters decreases trading volume but increases bid-ask spreads and pricing bouncing in the cross-section and across time. Parameter uncertainty increases during the crisis period, and negatively impacts market liquidity. But there is weak evidence that parameter uncertainty may help forecast liquidity in the corporate bond market. Collectively the empirical results provide a rationale for time-varying liquidity dynamics in the corporate bond market.