Goal of the Research: To study the influence of bond liquidity on a discount / haircut when entering a REPO deal with it.
Empirical Base of Research: Bond bid/ask quotes from Bloomberg, and CDS quotes from Reuters, both for 2009 – 2012.
Results of the Research: We stated the world best practices in pricing REPO deals and managing inherent risks. We studied the joint dynamics of the bonds and CDS quotes. The results show that the CDS market reacts on news before the bond market. We also show that the theoretical relation between bond and CDS spreads does not necessarily hold in practice, depending on the term structure of interest rates, maturity, credit quality and liquidity of the bonds in question. We also propose an approach to determining the liquidity premium in bond quotes using CDS quotes. Finally, we propose a general algorithm of pricing bond REPO deals, and list relevant factors and microstructural effects, which might be included in the model.
Level of implementation, recommendations on implementation or outcomes of the implementation of the results: This is a theoretical work with empirical observations. Further empirical work, including numerical experiment is much desired.
Field of Application: counterparty risk management, and pricing central counterparty REPO deals within an exchange.