Disentangling types of liquidity and testing limits‐to‐arbitrage theories in the CDS–bond basis

We disentangle asset‐specific, market, and funding liquidity in the CDS–bond basis outside and during the 2007–9 global financial crisis. Our findings stress the importance of separating different types of liquidity, since all three measures have independently negative impacts on the basis. Funding liquidity emerges as the economically most important liquidity metric. While asset‐specific liquidity is cross‐correlated in both the cash and derivative markets, funding and market liquidity only matter for the cash market. We exploit the decomposition of the basis to test predictions of limits‐to‐arbitrage theories. We find strong evidence in favor of margin‐based asset pricing and flight‐to‐quality effects.