Optimal Dealer Behaviour and Market Liquidity in the Corporate Bond Market after Post Financial Crisis Regulation

Abstract

The aim of this master thesis is to investigate optimal behaviour of a dealer in the over-the-counter corporate bond market. After implementation of the post financial crisis regulation, inventory of bank aÿliated dealers was observed to be lower than before the financial crisis despite observed narrow spreads. This motivates a profound investigation of dealer behaviour during this period. Thus, the relation between dealer behaviour and inventory is of particular interest. The master thesis consists of three parts. The first part describes the theoretical optimal dealer behaviour by Ho & Stoll (1981) where important factors that influence bid-ask spread and price adjustment are presented. Dealer behaviour is shown to be largely influenced by the risk associated with a trade and hence also the dealer’s risk aversion. The second part investigates dealer behaviour based on the critique of The Volcker Rule in Duÿe (2012) through a numerical illustration. It is discussed and concluded that spreads are likely to stay on the same level as before implementation due to the dealer’s new incentives in view of the regulation, and despite the e˙ect from low amount of collateral. This does however not indicate deterioration of market liqudity as Duÿe predicted, as this would involve larger spreads when the spread is used to measure market liquidity. The third part of this thesis is an empicial study of dealer behaviour based on the dealer’s overnight capital commitment, collateral and chosen spread. The study concludes that spreads stay narrow after the The Volcker Rule whereas collateral and overnight capital commitment decline. The significant relationship between collateral and overnight capital commitment shows that market liquidity does deteriorate. Hence, only evaluating market liquidity based on spread is not enough to measure market liquidity after the post crisis regulation as it conceals information of the market condition. Overnight capital commitment, on the other hand, captures the deterioration of market liquidity and is scrutinized in this master thesis. The master thesis concludes that the theoretical model clarifies narrow spreads shown in the empirical study after The Volcker Rule. Thus, it is shown that the post crisis regula-tion had an impact on dealer behaviour and deterioration of market liquidity. Hence, this master thesis contributes to the literature with a theoretical and empirical rationalization of dealers’ low inventories and narrow spreads where dealer behaviour can be accounted for.