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Limits to arbitrage and the term structure of bond illiquidity premiums

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  • Schuster, Philipp
  • Uhrig-Homburg, Marliese

Abstract

Theoretical models suggest that the relation of speculators’ capital and market liquidity is highly nonlinear. Changes in capital only marginally affect liquidity when capital is available abundantly, but have a large effect when capital is scarce. In this paper, we confirm this relation within a regime-switching model using three broad measures of German bond market liquidity. We then analyze how the term structure of illiquidity premiums of German agency bonds is related to intermediaries’ capital and foreign flows. Illiquidity premiums are related to both variables only in the stress regime. The effect of intermediaries’ capital is most strongly pronounced at the short end of the term structure. In contrast, flows into and out of the illiquid bond market segment constitute a level effect as they are related to illiquidity premiums of all maturities.

Suggested Citation

  • Schuster, Philipp & Uhrig-Homburg, Marliese, 2015. "Limits to arbitrage and the term structure of bond illiquidity premiums," Journal of Banking & Finance, Elsevier, vol. 57(C), pages 143-159.
  • Handle: RePEc:eee:jbfina:v:57:y:2015:i:c:p:143-159
    DOI: 10.1016/j.jbankfin.2014.10.016
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    2. repec:eee:jimfin:v:75:y:2017:i:c:p:14-31 is not listed on IDEAS
    3. Stefan Fiesel & Marliese Uhrig-Homburg, 2016. "Illiquidity Transmission in a Three-Country Framework: A Conditional Approach," Schmalenbach Business Review, Springer;Schmalenbach-Gesellschaft, vol. 17(3), pages 261-284, December.
    4. Dubecq, Simon & Monfort, Alain & Renne, Jean-Paul & Roussellet, Guillaume, 2016. "Credit and liquidity in interbank rates: A quadratic approach," Journal of Banking & Finance, Elsevier, vol. 68(C), pages 29-46.
    5. Abudy, Menachem Meni & Raviv, Alon, 2016. "How much can illiquidity affect corporate debt yield spread?," Journal of Financial Stability, Elsevier, vol. 25(C), pages 58-69.

    More about this item

    Keywords

    Bond liquidity; Term structure of illiquidity premiums; Regime-switching; Financial crisis; Slow moving capital; Limits to arbitrage;

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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