Liquidity risk and correlation risk: a clinical study of the General Motors and Ford downgrade of May 2005
Journal
Quarterly Journal of Finance
Subject
Finance
Publishing details
Authors / Editors
Acharya V;Schaefer S;Zhang Y
Biographies
Publication Year
2015
Abstract
The deterioration in credit quality of General Motors (GM) and Ford to junk status in the spring of 2005 caused a wide-spread sell-off in their corporate bonds. Using a novel dataset, we document that this sell-off appears to have generated significant liquidity risk for market-makers, as evidenced by a significant imbalance in their quotes towards sales. We find that simultaneously there was a substantial increase in the co-movement between innovations in the credit default swap (CDS) spreads of GM and Ford and those of firms in all other industries, the increase being the greatest during the period surrounding the actual downgrade and reversing sharply thereafter. We show that the corporate bond market makers' imbalance towards sales in GM and Ford bonds explains a significant portion of this co-movement. These results linking liquidity risk and correlation risk are consistent with models in which market prices are episodically determined by the limited risk-bearing capacity of financial intermediaries.
Keywords
Market liquidity; Funding liquidity; Excess co-movement; Inventory risk; Financial crises
Available on ECCH
No
