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Credit informational asymmetries

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In Glosten (1994), as well as in Viswanathan and Wang (2002) and Biais, Martimort and Rochet (2000), liquidity suppliers can only submit limit orders and liquidity demanders can only use market orders to hit the existing quotes; it follows that in these models agents are not allowed to choose between limit and market orders. In real markets, of course, at the very least the agents submitting orders to an LOB can choose between limit and market orders.

The choice between limit and market orders is a strategic element in any trading decision and depends on the relative probability of execution of the two orders, which in turn depends on a variety of factors, such as the asymmetry of the personal evaluations of the risky asset between the agents who submit the orders and those who hit the existing quotes, their degree of patience, their waiting costs and the state of the LOB. In the recent literature there are a few models for an LOB which embody the choice between market and limit orders; with the exception of Goettler, Parlour and Rajan (2008), in these early models there is no asymmetric information on the asset value.8 It is important, however, to understand the theory on the optimal traders’ submission strategies even when transaction costs are not due to informational asymmetries because there is evidence that non-informational frictions can be substantial; for example, Huang and Stoll (1997) show that on average they account for more than 80 per cent of the spread.

General fluctuations of credit spreads

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BBB-rated corporate bonds obviously have a very high correlation to fluctuations of credit spreads in general. Although they made up on average only 25 percent of the Euro investment grade market, the influence of lower rated bonds on market spreads is substantial. Higher quality bonds, on the other hand, exhibit lower correlations to market spread changes. One reason is that their impact on the market direction is less pronounced because they are less volatile. But the second reason is probably more important. Euro corporate bonds are typically valued against swaps, that is the spread versus government bonds consists of two components: the swap spread and the spread over swaps. As a consequence changes of swap spreads have an influence on the spread of a corporate bond versus duration-matched treasuries. The higher the credit quality and the lower the spread of an issuer, the higher is the fraction of the benchmark spread that is due to the swap spread.

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