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Liquidity and Trading in Bond and Derivatives Markets II

Paper Session

Sunday, Jan. 8, 2017 1:00 PM – 3:00 PM

Sheraton Grand Chicago, Sheraton Ballroom III
Hosted By: American Finance Association
  • Chair: Samuel Hanson, Harvard Business School

Funding Value Adjustments

Leif Andersen
,
Bank of America-Merrill Lynch
Darrell Duffie
,
Stanford University
Yang Song
,
Stanford University

Abstract

We demonstrate that large funding value adjustments (FVAs) being made by derivatives dealers to the disclosed valuations of their swap books are not consistent with any coherent notion of fair market value. Essentially the same funding cost adjustment is a reduction in the dealer's equity value.
This reduction in equity value is exactly offset by the sum of an upward adjustment to a dealer's debt valuation (as a wealth transfer from shareholders) and a change in the present value of the dealer's financial distress costs. While others have already suggested that FVA accounting suffers from coherence problems, this paper is the first to identify and characterize these problems in the context of a full structural model of a dealer's balance sheet. In addition to giving an appropriate theoretical foundation for funding value adjustments, our model shows how dealers' bid and ask quotes should be adjusted so as to compensate shareholders for the impact of both funding costs and the dealer's own default risk. We also establish a pecking order for preferred swap financing strategies, characterize the valuation effects of initial margin financing (known as ``MVA''), and provide a new interpretation of the standard debit value adjustment (DVA).

Trading Frictions in the Interbank Market and the Central Bank

Jean-Edouard Colliard
,
HEC Paris
Thierry Foucault
,
HEC Paris
Peter Hoffmann
,
European Central Bank

Abstract

We present a core-periphery model of trading in the overnight interbank market. We model periods of crises as an increase in the number of peripheral banks that lose access to core dealers, resulting in segmentation between core and peripheral markets. Our model implies that such an increase in segmentation raises (i) the bargaining power of periphery banks connected to the core, (ii) the dispersion of prices in the interbank market, and (iii) inefficient resort to the central bank standing facilities. We argue that these implications are consistent with stylised facts about the interbank market and propose new predictions about trading in a segmented OTC market.

Liquidity and Price Pressure in the Corporate Bond Market: Evidence From Mega-Bonds

Jean Helwege
,
University of California-Riverside
Liying Wang
,
University of Nebraska-Lincoln

Abstract

Larger bonds offer greater liquidity, which would be expected to reduce their yields, all else constant. However, they may be difficult to place. We consider the trade-off of liquidity and price pressure in determining whether firms issue a single large bond or several smaller bonds. We find that mega-bonds have high liquidity, but they do not enjoy lower yields and actually appear to have higher yields because of price pressure. Mega-bonds have more underpricing, their yields fall in the first week of trading, and other bonds of the issuing firms experience a temporary jump in yields when the mega-bonds are placed. We conclude that firms that raise very large amounts often split the bond offering across time or by maturity to avoid price pressure.

The Cost of Immediacy for Corporate Bonds

Jens Dick-Nielsen
,
Copenhagen Business School
Marco Rossi
,
Texas A&M University

Abstract

Liquidity provision in the corporate bond market has become significantly more
expensive after the 2008 crisis. Using index exclusions as a natural experiment
during which uninformed index trackers request immediacy, we find that the
cost of immediacy has doubled for short-term investment-grade bonds, and
more than tripled for speculative-grade bonds. In addition to this level effect
the supply of immediacy has become more elastic with respect to its price.
Consistent with higher cost of holding inventory in a more stringent regulatory
environment with smaller dealer portfolios, we also find that dealers revert
deviations from their target inventory more quickly after the crisis.
Discussant(s)
Martin Oehmke
,
Columbia University
Ana Babus
,
Federal Reserve Bank of Chicago
Christian Lundblad
,
University of North Carolina-Chapel Hill
Jack Bao
,
Federal Reserve Board
JEL Classifications
  • G1 - Asset Markets and Pricing