Types of liquidity and limits to arbitrage—the case of credit default swaps

Authors


  • Initial work on this study was completed when the first author was a Visiting Professor at the Stern School, New York University. We are thankful to David Manzler, Lalatendu Misra, and seminar participants at the FMA meetings and University of Texas at San Antonio. This research was supported in part by a summer research grant by US Global Investors.

Correspondence author, College of Business, University of Texas at San Antonio, One UTSA Circle, San Antonio, TX 78249. Tel: 210-458-7429, Fax: 210-458-6320

Abstract

Using a sample of Credit Default Swap (CDS) prices and corresponding reference corporate bond yield spreads for the period June 2008 to September 2009, we show that funding liquidity (shadow cost of capital for arbitrageurs) as well as asset-specific liquidity (determinants of margin requirements) explain recent deviations in the arbitrage-based parity relationship between the CDS prices and bond yield spreads (CDS-Bond spread basis). Collectively, our analysis corroborates the theory on the determinants of the basis, and suggests that it is important to distinguish between these types of liquidity in determining the circumstances in which relative prices will converge. Median annualized returns for a sample convergence type trading strategy with typical levels of leverage are 80% with a median holding-period of 127 days, but the path to convergence is not smooth. © 2011 Wiley Periodicals, Inc. Jrl Fut Mark

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