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Market Liquidity in a Natural Experiment: Evidence from CDS Standard Coupons

Published online by Cambridge University Press:  01 March 2024

Xinjie Wang Open the ORCID record for Xinjie Wang [Opens in a new window] ,
Ge Wu  and
Zhaodong (Ken) Zhong
Xinjie Wang*
Affiliation:
Department of Finance, Business School, Southern University of Science and Technology
Ge Wu
Affiliation:
Robins School of Business, University of Richmond [email protected]
Zhaodong (Ken) Zhong
Affiliation:
Department of Finance and Economics, Rutgers Business School, Rutgers University [email protected]
*
[email protected] (corresponding author)
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Abstract

The credit default swap (CDS) Big Bang introduced 2 standard coupons for CDS trading. We exploit the setting of the 2 standard coupons as a natural experiment to quantify the components of the bid–ask spreads in over-the-counter markets. We find that a significant portion of the difference in the bid–ask spread between the 2 coupons is explained by the difference in funding costs. Furthermore, search intensity also explains the variation in the difference in bid–ask spread. The liquidity typically concentrates on one of the standard coupons and can suddenly switch to the other coupon. Using the sudden switch of the primary coupon, we provide further evidence to support the predictions of search-based liquidity models.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , First View , pp. 1 - 27
Copyright
© The Author(s), 2024. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

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Footnotes

We are grateful for the valuable comments from an anonymous referee, Raymond Fishe, Esen Onur, George Pennacchi (the editor), Julia Reynolds (discussant), Michel Robe, and Hongjun Yan as well as from conference or seminar participants of the 2022 Financial Management Association Annual Meeting and Commodity Futures Trading Commission. Wang acknowledges financial support from the National Natural Science Foundation of China (Project No. 72171107), Southern University of Science and Technology (Grant No. Y01246110), and Shenzhen Stability Support Program Project (Project No. 20231121095510002).

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