Dealer Liquidity Provision and the Breakdown of the Law of One Price: Evidence from the CDS-Bond Basis

Abstract

We examine dealers' liquidity provision against mispricing in the corporate bond market from 2005 to 2009. Dealers on average serve as stabilizing liquidity providers by trading against widening price gaps between corporate bonds and credit default swaps (the CDS-bond basis). However, dealers provide less liquidity as they suffer losses, mispricing becomes wider, or funding situation worsens, consistent with the limited capital capacity of financial intermediaries. We also show that the unwinding of basis arbitrage trading can amplify mispricing by documenting that bond returns following Lehman's collapse were substantially low for bonds with strong pre-existing basis arbitrage activity and for bonds underwritten by Lehman Brothers. Liquidity demand due to the exit of arbitrageurs can be a major driver of disruption in credit markets.