Financial Stability Risk. Measuring the Illiquidity of Corporate and Sovereign Bonds

Master's Thesis , 2016 , 95 Pages , Grade: 1,3

Economics - Other

Market liquidity is most important for financial markets and thus for the real economy. Market-makers seem to provide less liquidity recently. The reasons of such a behaviour are shown within this work. It exhibits the regulations which have changed, the behaviour of market-makers and how financial markets are able to become illiquid. After this more theoretical framework, which refers to financial stability, several measures of liquidity are introduced and empirically tested on a dataset of about 60,000 corporate and sovereign bonds in 34 countries over a period of eleven years. The result, is that bond markets became less liquid within the last three years than during the financial and the following European debt crisis.

Inhaltsverzeichnis (Table of Contents)

• 1 Introduction
• 2 Review of the Regulation Development of Financial Markets
• 3 Liquid Market and Market-Making
  • 3.1 Market Liquidity
    • 3.1.1 Swiss Franc Revaluation
    • 3.1.2 The Taper Tantrum
    • 3.1.3 Treasury Market Rally and Volatility of European Sovereign Bonds
  • 3.2 Principles and Importance of Market-Making
  • 3.3 Market-Making Versus Proprietary Trading
  • 3.4 Modelling Market-Making
    • 3.4.1 A Simple Model of Market-Making
    • 3.4.2 The Case of Fixed Income
    • 3.4.3 The Case of Lower Risk-Adjusted Return
    • 3.4.4 The Case of Non-Falling Interest Rates
  • 3.5 Change of Market-Making
    • 3.5.1 Trends in Market-Making and the Behaviour of Market-Makers
    • 3.5.2 Drivers of the Trend
  • 3.6 Danger of a Dry-Up
    • 3.6.1 A Model of Herd Behaviour
      • 3.6.1.1 Herding Measure
      • 3.6.1.2 Herding over Time and Price Impacts
    • 3.6.2 A Model of Self-Fulfilling Liquidity Dry-Ups
      • 3.6.2.1 Structure of the Model
      • 3.6.2.2 Equilibrium
      • 3.6.2.3 Externality and the Result of the Model
  • 3.7 The Link between Liquid Markets and the Real Economy
    • 3.7.1 The Households
    • 3.7.2 A Household's Decisions
    • 3.7.3 The Equilibrium
    • 3.7.4 Result of a Liquidity Shock
• 4 Data
• 5 Estimating Illiquidity
  • 5.1 Related Literature
  • 5.2 Bid-Ask Spreads
  • 5.3 The Conventional Liquidity Ratio
  • 5.4 Amihud Illiqudity Ratio
  • 5.5 The Index of Martin
  • 5.6 Marsh and Rock's Liquidity Ratio
  • 5.7 Change of Prices
  • 5.8 Bao-Pan-Wang Model
    • 5.8.1 Measuring Illiquidity
    • 5.8.2 A Dynamic Approach

Zielsetzung und Themenschwerpunkte (Objectives and Key Themes)

This master thesis investigates the illiquidity of corporate and sovereign bonds, a crucial factor in the stability of financial markets and the real economy. It aims to understand how market-makers, the key players in providing liquidity, have been affected by regulatory changes and how this impacts the liquidity of financial markets. The thesis explores the theoretical framework of financial stability and introduces various measures of liquidity, which are then empirically tested on a large dataset. Key themes include:

• The role of market-makers in financial markets
• The impact of regulations on market-making behavior
• The measurement of illiquidity in bond markets
• The relationship between market liquidity and the real economy
• The potential for liquidity dry-ups and their consequences

Zusammenfassung der Kapitel (Chapter Summaries)

• Chapter 1: Introduction - This chapter sets the stage for the thesis, outlining the importance of market liquidity and the growing concern over its decline. It introduces the research question and outlines the structure of the thesis.
• Chapter 2: Review of the Regulation Development of Financial Markets - This chapter provides a historical overview of the regulatory changes affecting financial markets, highlighting their impact on market-making activities.
• Chapter 3: Liquid Market and Market-Making - This chapter delves into the concept of market liquidity and the crucial role of market-makers. It explores the principles of market-making, the distinction between market-making and proprietary trading, and the modelling of market-making behavior. The chapter also analyzes the changing trends in market-making, including the drivers of these changes and the potential dangers of liquidity dry-ups.
• Chapter 4: Data - This chapter describes the data used in the empirical analysis, including the dataset of corporate and sovereign bonds, the time period covered, and the specific variables analyzed.
• Chapter 5: Estimating Illiquidity - This chapter reviews various measures of illiquidity used in the literature and introduces a new approach to measuring illiquidity based on the Bao-Pan-Wang model. The chapter then applies these measures to the dataset to assess the evolution of illiquidity in bond markets.

Schlüsselwörter (Keywords)

This master thesis focuses on the crucial concept of market liquidity, particularly examining the illiquidity of corporate and sovereign bonds. Key themes include the role of market-makers in providing liquidity, the impact of regulations on their behavior, and the measurement of illiquidity using various methodologies. The research explores the relationship between market liquidity and the real economy, emphasizing the potential for liquidity dry-ups and their consequences. Important terms and concepts include market liquidity, market-makers, illiquidity, financial stability, corporate and sovereign bonds, and empirical research.

• College: University of Siegen
• Grade: 1,3
• Author: Thorsten Foltz (Author)
• Publication Year: 2016
• Pages: 95
• Catalog Number: V354737
• ISBN (eBook): 9783668410244
• ISBN (Book): 9783668410251
• Language: English
• Tags: financial, stability, risk, measuring, illiquidity, corporate, sovereign, bonds