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Search friction, liquidity risk, and bond misallocation

Author

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  • Liu, Shuo

Abstract

Search friction is a key driver of changes in corporate bond yield spreads over time. In the cross-section, the liquidity risk stemming from search friction is significantly priced, and is strongly correlated with the misallocation of bond positions among different traders. I propose a novel measure of bond-specific misallocation, which is the negative covariance between traders’ private valuations and their inventory positions for each bond. I find that bonds with higher levels of misallocation are associated with lower absolute levels of liquidity risk from search friction. I develop a search-and-matching model to explain this correlation.

Suggested Citation

  • Liu, Shuo, 2024. "Search friction, liquidity risk, and bond misallocation," Journal of Financial Markets, Elsevier, vol. 70(C).
    • Handle: RePEc:eee:finmar:v:70:y:2024:i:c:s1386418124000302
    DOI: 10.1016/j.finmar.2024.100912
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    Keywords

    Corporate bond market; Bond misallocation; Liquidity risk; Search friction;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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