|
Archive@NYU >
Stern School of Business >
Finance Working Papers >
Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/27853
|
| Title: | Limited arbitrage and liquidity in the market for credit risk |
| Authors: | Subrahmanyam, Marti
Nashikkar, Amrut
Mahanti, Sriketan |
| Issue Date: | 2-Feb-2009 |
| Series/Report no.: | FIN-08-011 |
| Abstract: | Recent research has shown that default risk accounts for only a part of
the total yield spread on risky corporate bonds relative to their
risk-less benchmarks. One candidate for the unexplained portion of the
spread is a premium for liquidity. We investigate this possibility by
relating the liquidity of corporate bonds to the basis between the
credit default swap (CDS) price of the issuer and the parequivalent
corporate 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.
However highly illiquid bonds with high default risk 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 variables related
to credit risk affect the basis, indicating that the CDS price does not
fully capture the credit risk of the bond. |
| URI: | http://hdl.handle.net/2451/27853 |
| Appears in Collections: | Finance Working Papers
|
All items in Faculty Digital Archive are protected by copyright, with all rights reserved.
|
