Price discovery and persistent arbitrage violations in credit markets

• Author: Chunchi Wu,Junbo Wang,Kasing Man,Hai Lin
• Published date: 01 March 2020
• DOI: http://doi.org/10.1111/fima.12261
• Date: 01 March 2020

DOI: 10.1111/fima.12261

ORIGINAL ARTICLE

Price discovery and persistent arbitrage violations

in credit markets

Hai Lin1Kasing Man2Junbo Wang3Chunchi Wu4

1School of Economics and Finance, Victoria

University of Wellington,Wellington, New

Zealand

2College of Business and Technology,Western

Illinois University, Macomb, IL

3School of Economics and Finance, City

University of Hong Kong,Kowloon Tong, Hong

Kong

4School of Management, State University of New

Yorkat Buffalo, Buffalo, NY

Correspondence

ChunchiWu, School of Management, State Uni-

versityof New York at Buffalo, Buffalo, NY.

Email:chunchiw@buffalo.edu

Abstract

This paper investigatesprice violations in credit markets using a data

samplespanning from 2002 to 2016. We find that price violations are

highlypersistent during the crisis period, particularly for speculative-

grade bonds. There is evidencethat price distortions and market dis-

integration are linked to market-wide and firm-level impediments

to arbitrage and limited capital provision. Higher firm-level impedi-

ments to arbitrage lead to less market integration, and more severe

and persistent pricing discrepancies. Moreover,we find that the neg-

ative CDS basis persists in the postcrisis period, which is attributable

to dealers’ lower capital commitment and deterioration in market-

making quality.

1INTRODUCTION

The arbitrage-free condition has been a building block in the development of modern financial and asset pricing theo-

ries. Forexample, standard term structure models build on the assumption of no-arbitrage conditions, and asset pricing

theory assumes that any temporary deviations of prices from efficient benchmarks can be arbitragedaway quickly by

rational traders.However, it has been shown that the arbitrage-free condition has often been violated in financial mar-

kets (see Kapadia & Pu, 2012) and that violations were especially severe during the subprime crisis (see Duffie, 2010;

Mitchell & Pulvino, 2012).1In particular, acute price violations in credit marketsduring the crisis attracted consider-

able attention. The credit default swap (CDS) basis, or the difference between the CDS rate and yield spreads of a par

bond with the same maturity as the CDS, widened to above 600 basis points after the collapse of LehmanBrothers. As

Duffie pointed out in his 2010 American Finance Association presidential address, “The extreme negative CDS basis

‘violations’ …across broad portfolios of investment-grade bonds and high-yield bonds, respectively,is far too large to

be realistically explained byCDS counterparty risk or by other minor technical details.”

CDS and bond yield spreads both reflect a firm's credit risk premium. In a frictionless market, any discrepancy in

these two variables will be eliminated quickly by arbitrage. This suggests that the CDS basis should be close to zero if

arbitrageis perfect. However, arbitrage is rarely perfect, as cash flows of CDS and the reference obligation are typically

c

2019 Financial Management Association International

1Forexample, there were serious violations of covered interest rate parity, a negative spread between Treasurybond yields and London Inter-Bank Offered

Rate(LIBOR) swap rates, and a breakdown of the capital structure arbitrage across equity and credit markets.

Financial Management. 2020;49:207–233. wileyonlinelibrary.com/journal/fima 207

208 LIN ET AL.

not perfectly aligned. There are also other complications; for instance, physically settled CDS prices contain the value

of the cheapest-to-delivery (CTD) option, and arbitrage may require shorting the cash bond which can be costly or

sometimes infeasible. Past studies prior to the subprime crisis have shown that the CDS basis was close to zero, or

slightly positive, which can be attributed to the CTD option value or costly short selling. The huge negative CDS basis

that occurred during the subprime crisis is thus more difficult to explain, and posts significant challenges to rational

no-arbitrage pricing theory.

Violations of the arbitrage-based pricing relationship have profound implications for market efficiency and asset

pricing. In particular,persistent price violations can cause asset price distortions and market disintegration. The litera-

ture has suggested various sources of asset mispricing. Price violations are commonly attributed to limits-to-arbitrage

(see Brav,Heaton, & Li, 2010; Mitchell & Pulvino, 2012; Pontiff, 2006; Shleifer & Vishny, 1997). Arbitrage maynot be

feasible when transactioncosts and the risk of a firm's security are excessively high. Funding constraints or limited arbi-

trage capital provision can prevent arbitrageactivity (Brunnermeier & Pedersen, 2009; Mitchell & Pulvino, 2012) and

cause serious mispricing in similar securities.

Inthis paper, we examine the issues related to the violation of arbitrage-free pricing relations in credit markets using

a data sample spanning from 2002 to 2016, which covers both the crisis and normal periods. Weemploy two methods

to assess the severity of pricing violations in credit markets. First, using a vector error-correction model (VECM), we

examinethe dynamics of CDS and bond spreads, and conduct a test on the equivalence of the prices of credit risk across

the two markets overtime via cointegration analysis. Second, we perform a nonparametric model-free test for market

integration based on the concordance of price changes in the CDS and bond markets.

A unique character of the price distortion during the subprime crisis is that pricing discrepancies are not only large

but also highly persistent. Besides studying the magnitude of CDS-bond mispricing, we adopt a long memory model to

quantify the persistence in pricing discrepancies, an issue which is much less studied in the literature. The long memory

model provides a generic time-series measure of persistence or long-range dependency (see Hosking, 1981; Lo,1991;

Zivot & Wang, 2006), which characterizesthe slow-moving nature of arbitrage capital in times of stress very well. An

advantage of this model is that the persistence in pricing discrepancies due to arbitrage capital shortage or other fric-

tions can be nicely summarized by a parsimonious parameterthat measures how slowly moving the arbitrage capital is

and how persistent the resulting price violations are. After identifying the pricing discrepancies and their persistence

in credit markets, we exploretheir relations to impediments to arbitrage at both the market and firm levels.

We document several interesting findings that contribute to the current literature. First, both cointegration and

nonparametric tests show that pricing discrepancies across firms’ CDS and bond marketsare common and much more

serious in the crisis period. The level and volatility of CDS-bond pricing discrepancies can be quite persistent. The

persistence in price discrepancies is much stronger in the crisis period than during normal periods, and is higher for

noninvestment-grade(IG) bonds than for IG bonds.

Second, we find that both the magnitude and persistence of price discrepancies are closely related to firm-level and

market-wide impediments to arbitrage. Consistent with the theory of costly arbitrage(Shleifer & Vishny, 1997), firms

with high risk, illiquidity, leverage,and return volatility experience more severe and persistent pricing discrepancies.

Violations of price convergence are also more frequent, and price discrepancies are larger and more persistent in the

period when funding constraints are high and market liquidity dries up. The relative role of firm-levelimpediments to

systematic (market-wide) impediments depends on market conditions. We find that firm-level impediments to arbi-

trage play a nontrivial role in CDS-bond pricing violations during normal market periods, but that in times of stress,

systematic impediments become more important factors.

Third, there is evidence that slow capital movementaggravates the persistence of price violations in credit markets

during the subprime crisis. Using several proxies for arbitrage capital provision, we find that the sensitivity of firms

to funding availability has high explanatory power for the persistence of price violations in credit markets in times of

stress. In addition, the funding-related variables exhibit a strong persistence pattern during the crisis period which

coincides with the persistence in CDS-bond pricing discrepancies. These findings lend support to the contention that

persistence in the shortage of arbitrage capital causes persistence in pricing discrepancies in credit markets.