Providing liquidity in an illiquid market: Dealer behavior in US corporate bonds

Michael A. Goldstein and Edith S. Hotchkiss

Journal of Financial Economics, 2020, vol. 135, issue 1, 16-40

Abstract: We examine market making behavior of dealers for 55,988 corporate bonds, many of which trade infrequently. Dealers have a substantially higher propensity to offset trades within the same day rather than committing capital for longer periods for riskier and less actively traded bonds. Dealers’ holding periods do not decline with a bond's prior trading activity and in fact are lowest for some of the least active bonds. As a result, cross-sectional estimates of roundtrip trading costs do not increase as prior trading activity declines. Our results suggest that dealers endogenously adjust their behavior to mitigate inventory risk from trading in illiquid and higher risk securities, balancing search and inventory costs in equilibrium such that observed spreads can appear invariant to expected liquidity.

Keywords: Liquidity provision; Dealer behavior; Corporate bonds; Illiquidity; Roundtrip costs (search for similar items in EconPapers)
JEL-codes: G15 G23 G24 G28 (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (36)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:135:y:2020:i:1:p:16-40

DOI: 10.1016/j.jfineco.2019.05.014

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