Working Paper: CEPR ID: DP6619
Authors: Viral V. Acharya; Stephen M. Schaefer; Yili Zhang
Abstract: The GM and Ford downgrade to junk status during May 2005 caused a wide-spread sell-off in their corporate bonds. Using a novel dataset, we document that this sell-off appears to have generated significant liquidity risk for market-makers, as evidenced in the significant imbalance in their quotes towards sales. We also document that simultaneously, there was excess co-movement in the fixed-income securities of all industries, not just in those of auto firms. In particular, using credit-default swaps (CDS) data, we find a substantial increase in the co-movement between innovations in the CDS spreads of GM and Ford and those of firms in all other industries, the increase being greatest during the period surrounding the actual downgrade and reversing sharply thereafter. We show that a measure of liquidity risk faced by corporate bond market-makers ? specifically, the imbalance towards sales in the volume and frequency of quotes on GM and Ford bonds ? explains a significant portion of this excess co-movement. Additional robustness checks suggest that this relationship between the liquidity risk faced by market-makers and the correlation risk for other securities in which they make markets was likely causal. Overall, the evidence is supportive of theoretical models which imply that funding liquidity risk faced by financial intermediaries is a determinant of market prices during stress times.
Keywords: excess comovement; financial crises; funding liquidity; inventory risk; market liquidity
JEL Codes: G12; G13; G14; G21; G22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| liquidity risk (G33) | correlation risk (C10) |
| downgrade of GM and Ford to junk status (G33) | selloff of corporate bonds (G33) |
| selloff of corporate bonds (G33) | liquidity risk for market makers (G10) |
| liquidity risk for market makers (G10) | excess comovement in CDS spreads (E44) |
| heightened inventory risk (G31) | adjustment of prices across the board (P22) |
| adjustment of prices across the board (P22) | increased spreads in the CDS market (F65) |
| liquidity risk measures (G33) | CDS innovations (O39) |