Violations of the Law of One Price in Credit and Swap Markets During Market Distress

Abstract

This thesis is devoted to investigating the dynamic properties of Law of One Price (LOP) violations around periods of market distress. It studies the extent to which these violations are state-dependent and how they are related to different market conditions. The role of monetary policies and hedge funds in contributing to LOP equilibrium are also analysed. First part focuses on the construction of an LOP deviation proxy called Basis(bond), derived from the foreign-currency sovereign bond markets (in USD and Euro) of three main emerging economies (i.e. Brazil, Mexico and Turkey). It is observed that Basis(bond) moves close to zero (supporting LOP condition) during good states of economy (Pre-Crisis), whereas it becomes markedly large, persistent and volatile during bad states of economy (Credit Crisis). Second part delves deeper into why Basis(bond) deviated so markedly from zero during 2008-2009 Credit Crisis. We find strong evidence that rising funding costs, falling bond supply, intensified risk aversion and deteriorated default risk coupled with macroeconomic shocks are responsible in deterring arbitrageurs from exploiting the trading strategy, and inducing relative price divergence. Depending on the geography of bond issuance, there exist cross-sectional idiosyncrasies regarding the sign of deviation. While Turkey tends to pay smaller credit risk premium in Euro compared to USD, the opposite is true for Brazil and Mexico. When investors face discordant default risks across two equivalent securities, the underlying trading strategy is left unexploited. Moreover, there is strong evidence that different sets of monetary policies have different implications in resolving LOP disequilibrium. Third part investigates the impact of arbitrageurs (particularly hedge funds) in supplying liquidity to markets, and thus contributing to correct relative valuation of mispriced securities. It is confirmed that hedge fund withdrawal, due to severe capital reduction, contributes adversely to the growth of LOP deviations in credit and swap markets.