Essays on Institutional Frictions in Fixed Income Markets

Abstract

This dissertation studies how financial markets can be distorted by institutions and their trading frictions. In particular, I study how thin and illiquid markets, concentrated risks and intermediaries' asset inventory lead to financial and agency frictions in three fixed income settings: corporate bond exchange-traded fund (ETF) arbitrage, Treasury security auction spillovers, and variance risk pricing in the equity options market. The first chapter studies the role of liquidity mismatch in the arbitrage of ETFs with illiquid underlying assets. ETF arbitrage can become distorted as a result of authorized participants' dual roles as bond dealers in the underlying corporate bond market as well as the only intermediaries able to perform bond-ETF arbitrage. Using novel and granular data on ETF arbitrage and AP corporate bond inventory, we show empirical evidence consistent with a potential distortion of ETF arbitrage due to inventory management motives, as well as asset price dynamics -- both in the ETF and in the underlying bond market -- due to persistent relative ETF mispricings. The second chapter examines cross-asset market spillovers in the corporate bond market following anticipated and repeated Treasury security auction supply shocks. Supply shocks must be absorbed on short notice by a limited set of investors -- primary dealers -- whose inter-temporal intermediation frictions require an initial corporate bond price impact followed by a price reversal. Corporate bond price impacts can be capitalized using trading strategies in assets with liquid credit exposure. These results are related to slow-moving capital and primary dealers' limited risk-bearing capacity, with direct implications for unconventional monetary policy. The third chapter shows that variance risk can be decomposed into a systematic component, earning a negative price of risk, and a (common) idiosyncratic component, earning a positive price of risk. Tension between the prices of risk provides a rational explanation for variance pricing differences across equity options, equity index options, and equities. Novel data on option market maker inventory risk in a large cross-section of equity options is used to characterize the dependence of variance risk premia on option market makers' inventory risk and limited risk-bearing capacity.