We explore the interaction between credit risk and liquidity, during the Euro-zone crisis, in the Italian sovereign bond market, using a unique tick-by-tick dataset, from the period June 2011-December 2012. We document a strong, dynamic relationship between changes in sovereign credit risk and market liquidity, conditional on the credit default swap (CDS) spread: When the CDS is above 500 basis points (bp), market liquidity adjusts more rapidly and signicantly to changes in the credit risk. Other global systemic factors also aect market liquidity, while, surprisingly, the specic credit risk of primary dealers plays only a modest role, especially under conditions of stress. Further, the Long-Term Renancing Operations (LTRO) by the European Central Bank (ECB) on December 8, 2012, clearly attenuated the relationship between credit risk and liquidity.
Liquidity; Government bonds; Financial crisis; MTS bond market
Main Research Area:
The 74th Annual Meeting of American Finance Association. AFA 2014