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Liquidity and tail-risk interdependencies in the euro area sovereign bond market

Daragh Clancy, Peter Dunne and Pasquale Filiani

Working Papers from European Stability Mechanism

Abstract: The likelihood of severe contractions in an asset's liquidity can feed back to the ex-ante risks faced by the individual providers of such liquidity. These self-reinforcing effects can spread to other assets through informational externalities and hedging relations. We explore whether such interdependencies play a role in amplifying tensions in European sovereign bond markets and are a source of cross-market spillovers. Using high-frequency data from the inter-dealer market, we find significant own- and cross-market effects that amplify liquidity contractions in the Italian and Spanish bond markets during times of heightened risk. The German Bund's safe-haven status exacerbates these amplification effects. We provide evidence of a post-crisis dampening of cross-market effects following crisis-era changes to euro area policies and institutional architecture. We identify a structural break in Italy's cross-market conditional correlation during rising political tensions in 2018, which significantly reduced liquidity. Overall, our findings demonstrate potential for the provision of liquidity across sovereign markets to be vulnerable to sudden fractures, with possible implications for euro area economic and financial stability.

Keywords: Liquidity; Tail risks; Feedback loops; Spillovers (search for similar items in EconPapers)
JEL-codes: F36 G01 G15 (search for similar items in EconPapers)
Pages: 57
Date: 2019-11-08
New Economics Papers: this item is included in nep-ban, nep-eec and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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