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Essays on Arbitrage and Market Liquidity A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Tomio, Davide Doctoral Thesis Essays on Arbitrage and Market Liquidity PhD Series, No. 22.2017 Provided in Cooperation with: Copenhagen Business School (CBS) Suggested Citation: Tomio, Davide (2017) : Essays on Arbitrage and Market Liquidity, PhD Series, No. 22.2017, ISBN 9788793579170, Copenhagen Business School (CBS), Frederiksberg, http://hdl.handle.net/10398/9482 This Version is available at: http://hdl.handle.net/10419/209030 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/ www.econstor.eu COPENHAGEN BUSINESS SCHOOL ON ARBITRAGE AND MARKET LIQUIDITY ESSAYS SOLBJERG PLADS 3 DK-2000 FREDERIKSBERG DANMARK WWW.CBS.DK ISSN 0906-6934 Print ISBN: 978-87-93579-16-3 Online ISBN: 978-87-93579-17-0 Davide Tomio ESSAYS ON ARBITRAGE AND MARKET LIQUIDITY The PhD School in Economics and Management PhD Series 22.2017 PhD Series 22-2017 Essays on Arbitrage and Market Liquidity Davide Tomio Supervisor: Lasse Heje Pedersen Ph.D. School in Economics and Management Copenhagen Business School Davide Tomio Essays on Arbitrage and Market Liquidity 1st edition 2017 PhD Series 22.2017 © Davide Tomio ISSN 0906-6934 Print ISBN: 978-87-93579-16-3 Online ISBN: 978-87-93579-17-0 “The PhD School in Economics and Management is an active national and international research environment at CBS for research degree students who deal with economics and management at business, industry and country level in a theoretical and empirical manner”. All rights reserved. No parts of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage or retrieval system, without permission in writing from the publisher. Preface This dissertation includes three essays I worked on during my Ph.D. studies at the Copenhagen Business School. While the papers overlap in their goal of understanding what drives market liquidity and the mispricing between securities connected by arbitrage, they are self-contained and can be read independently. Working on this dissertation over the past years, I benefited tremendously from the guidance and counsel of my advisers at CBS, Lasse Heje Pedersen and Søren Hvidkjær. They provided me with invaluable lessons and learning experiences and truly prepared me to tackle the academic job market. I am deeply indebted to my co-authors Marti G. Subrahmanyam, Loriana Pelizzon, and Jun Uno for their patience, support, kindness, and camaraderie. Their tireless will to show me the ropes of financial academia and their skills in investigating varied research questions are examples of mentorship and scholarship. I gratefully acknowledge the financial support of the FRIC Center for Financial Frictions (grant no. DNRF102) and the Volkswagen Foundation. Finally, this endeavor would have been overwhelming without the affection and friendship of many. I am thankful for the unwavering support and love of Troels, my family, and friends. Fellow Ph.D. students and faculty at CBS have contributed to making the last few years instructive and enjoyable. Davide Tomio New York City, April 2017 i ii Summary Summary in English Sovereign Credit Risk, Liquidity, and ECB Intervention: Deus ex Machina? With Loriana Pelizzon, Marti G. Subrahmanyam, and Jun Uno The first essay investigates how credit risk, the risk that a bond issuer will default, affects bond market liquidity. Specifically, we depart from the current literature in that we analyze the direct and indirect channels through which credit risk affects market liquidity, rather than determining whether both are priced in the bond. We focus on the Italian sovereign bond market, which allows us to determine how central bank interventions affect the sensitivity of the liquidity provision by market makers to default risk. We motivate our empirical analysis with a simple model of a risk averse market maker, holding an inventory of a risky asset and setting her optimal marginal quotes (and, therefore, the optimal bid-ask spread), in the presence of margin constraints and borrowing costs. The margins, set by a clearing house, depend on the risk of the asset, as measured by the CDS spread, and the actions of the central bank. The CDS market is fundamental to the market maker’s and the clearing house’s decisions, since it is from the CDS market that they deduce the future volatility of the asset return. In addition, the market maker can pledge her assets at the central bank to finance her positions at rates influenced by the central bank’s actions. The model provides several empirical predictions that we test in the empirical section of the paper. First, we test the empirical prediction that the relation between the credit risk of a sovereign bond and its liquidity is statistically significant and, specifically, that the credit risk, as measured by the CDS spread, leads the liquidity, and not the other way around. Second, we examine whether the relation between credit risk and market liquidity is conditional on the level of the CDS spread. We let the data identify the presence of such a CDS threshold effect, and find that the relation between market liquidity and credit risk is different, depending on whether the Italian CDS spread is below or above 500 bp. We interpret this finding, together with a change in the margins for bonds, in light of the predictions made by Brunnermeier and Pedersen (2009). Third, we analyze the impact of ECB intervention on the relation between credit risk and liquidity. Our test for an endogenous iii structural break indicates that, when the ECB allotted the funds of the LTRO program, the relation between the two variables changes significantly. Thereafter, during 2012, after the large amount of funding liquidity from the LTRO program has become available to market makers and market participants, changes in market liquidity respond to changes in credit risk with a significantly lower intensity. Arbitraging Liquidity The second essay investigates the effect that arbitrageurs have on the co-movement between the market liquidity of assets connected by an arbitrage relationship. In this paper, I argue that the level of arbitrage activity, defined by profiting from divergences of prices of identical securities across markets, contributes to the liquidity convergence between markets. By detailing the trading strategies available to an arbitrageur, I show in a simple trading framework how the market and limit orders submitted by arbitrageurs create co-movement across markets and lead to the convergence of bid prices, ask prices, and bid-ask spreads. I test this theoretical prediction empirically and show that the intensity of arbitrage activity contributes positively to the co-movement of market liquidity between securities linked by arbitrage. To do so, I employ high-frequency data for Canadian stocks cross-listed in the United States, to verify my hypotheses. Finally, I show the generality of my results by considering an alternative arbitrage trade, and showing that the liquidity commonality across stocks and corporate bonds is increasing in the amount of capital structure arbitrage activity. Employing data on the quotes of 125 Canadian stocks that are cross-listed in the United States, I determine, during each of the more than six million trading seconds of 2013, whether an arbitrage opportunity was available between the stock listed in the United States and its counterpart traded in Canada. I show that the co-movement between liquidity changes for securities connected by arbitrage is much larger for the sub-sample with few arbitrage opportunities, i.e., those with high arbitrage activity. For example, the correlation in liquidity changes over a one-minute interval is 7% for stock-days with a large number of arbitrage opportunities, and 25% for observations with a small number of arbitrage opportunities. Finally, I extend the previous finding outside the realm of stock markets alone, considering a different arbitrage trade, using capital structure arbitrage. I show that the commonality in liquidity between the bond and the stock market is higher when arbitrageurs are active, which supports the generality of my findings. Limits to Arbitrage in Sovereign Bonds With Loriana Pelizzon, Marti G. Subrahmanyam, and Jun Uno Commonality of liquidity refers to the linkages between liquidity across assets through common iv market-wide factors. We
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