Dealer Liquidity Provision and the Breakdown of the Law of One Price: Evidence from the CDS–Bond Basis

We examine dealers’ liquidity provision against mispricing in the corporate bond market from 2005 to 2009. Dealers on average serve as stabilizing liquidity providers by trading against widening price gaps between corporate bonds and credit default swaps (the CDS–bond basis). However, dealers cut back on liquidity provision as they suffer losses, mispricing becomes wider, or the funding situation worsens, consistent with the limited capital capacity of financial intermediaries. We also show that the unwinding of basis arbitrage trading can amplify mispricing by documenting that bond returns following the Lehman collapse were very low for bonds with strong preexisting basis arbitrage activity and for bonds underwritten by Lehman Brothers. Liquidity demand due to the exit of arbitrageurs can be a major driver of disruption in credit markets.

This paper was accepted by Lauren Cohen, finance.