Sovereign Credit Risk, Liquidity, and European Central Bank Intervention: Deus ex Machina?

Loriana  Pelizzon; Marti G.  Subrahmanyam; Davide Tomio; Jun Uno

doi:10.1016/j.jfineco.2016.06.001

Sovereign Credit Risk, Liquidity, and European Central Bank Intervention: Deus ex Machina?

Loriana Pelizzon, Marti G. Subrahmanyam, Davide Tomio, Jun Uno

Department of Finance

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Abstract

We examine the dynamic relation between credit risk and liquidity in the Italian sovereign bond market during the eurozone crisis and the subsequent European Central Bank (ECB) interventions. Credit risk drives the liquidity of the market. A 10% change in the credit default swap (CDS) spread leads to a 13% change in the bid-ask spread, the relation being stronger when the CDS spread exceeds 500 basis points. The Long-Term Refinancing Operations of the ECB weakened the sensitivity of market makers’ liquidity provision to credit risk, highlighting the importance of funding liquidity measures as determinants of market liquidity.

Original language	English
Journal	Journal of Financial Economics
Volume	122
Issue number	1
Pages (from-to)	86–115
Number of pages	30
ISSN	0304-405X
DOIs	https://doi.org/10.1016/j.jfineco.2016.06.001
Publication status	Published - Oct 2016

Keywords

Liquidity
Credit risk
Eurozone sovereign bonds
Financial crisis
MTS bond market

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Cite this

@article{a50dd5232e564edb982be9c5bf21e81e,

title = "Sovereign Credit Risk, Liquidity, and European Central Bank Intervention: Deus ex Machina?",

abstract = "We examine the dynamic relation between credit risk and liquidity in the Italian sovereign bond market during the eurozone crisis and the subsequent European Central Bank (ECB) interventions. Credit risk drives the liquidity of the market. A 10\% change in the credit default swap (CDS) spread leads to a 13\% change in the bid-ask spread, the relation being stronger when the CDS spread exceeds 500 basis points. The Long-Term Refinancing Operations of the ECB weakened the sensitivity of market makers{\textquoteright} liquidity provision to credit risk, highlighting the importance of funding liquidity measures as determinants of market liquidity.",

keywords = "Liquidity, Credit risk, Eurozone sovereign bonds, Financial crisis, MTS bond market, Liquidity, Credit risk, Eurozone sovereign bonds, Financial crisis, MTS bond market",

author = "Loriana Pelizzon and Subrahmanyam, \{Marti G.\} and Davide Tomio and Jun Uno",

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AU - Pelizzon, Loriana

AU - Subrahmanyam, Marti G.

AU - Tomio, Davide

AU - Uno, Jun

PY - 2016/10

Y1 - 2016/10

N2 - We examine the dynamic relation between credit risk and liquidity in the Italian sovereign bond market during the eurozone crisis and the subsequent European Central Bank (ECB) interventions. Credit risk drives the liquidity of the market. A 10% change in the credit default swap (CDS) spread leads to a 13% change in the bid-ask spread, the relation being stronger when the CDS spread exceeds 500 basis points. The Long-Term Refinancing Operations of the ECB weakened the sensitivity of market makers’ liquidity provision to credit risk, highlighting the importance of funding liquidity measures as determinants of market liquidity.

AB - We examine the dynamic relation between credit risk and liquidity in the Italian sovereign bond market during the eurozone crisis and the subsequent European Central Bank (ECB) interventions. Credit risk drives the liquidity of the market. A 10% change in the credit default swap (CDS) spread leads to a 13% change in the bid-ask spread, the relation being stronger when the CDS spread exceeds 500 basis points. The Long-Term Refinancing Operations of the ECB weakened the sensitivity of market makers’ liquidity provision to credit risk, highlighting the importance of funding liquidity measures as determinants of market liquidity.

KW - Liquidity

KW - Credit risk

KW - Eurozone sovereign bonds

KW - Financial crisis

KW - MTS bond market

KW - Liquidity

KW - Credit risk

KW - Eurozone sovereign bonds

KW - Financial crisis

KW - MTS bond market

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DO - 10.1016/j.jfineco.2016.06.001

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