We construct a model of the corporate bond market capturing the interaction of market maker behaviour,
fund trading strategies, and cash allocation by investors in funds to study feedback effects and the impact
of market changes. The model parameters are calibrated against empirical data on US corporate bond
trading. Where available, inputs are taken from market data. Others are calibrated through matching
statistical features of market returns such as auto-correlations, volatility and fat tails.
We use the model to explore the impact of shocks. We find that the sensitivity of the market maker to
demand and the degree to which momentum traders are active are key. While the behaviour of investors
in funds based on past experience plays a comparatively smaller role in model dynamics, it represents another
source of amplification which could be particularly problematic if investors respond to a shock with
greater risk aversion. Simple measures to reduce the speed with which investors can redeem investments
can reduce the extent of yield dislocation. We also explore the impact of the growth in passive investment,
and find that it increases the tail risk of big yield dislocations after shocks, though, on average,
volatility may be reduced. This highlights the importance of the interaction between trading behaviour
and market maker response, suggesting that measures to reduce the risk of momentum trading in a shock
such as disclosure may help mitigate the risk of overshoots in price adjustments.
fund trading strategies, and cash allocation by investors in funds to study feedback effects and the impact
of market changes. The model parameters are calibrated against empirical data on US corporate bond
trading. Where available, inputs are taken from market data. Others are calibrated through matching
statistical features of market returns such as auto-correlations, volatility and fat tails.
We use the model to explore the impact of shocks. We find that the sensitivity of the market maker to
demand and the degree to which momentum traders are active are key. While the behaviour of investors
in funds based on past experience plays a comparatively smaller role in model dynamics, it represents another
source of amplification which could be particularly problematic if investors respond to a shock with
greater risk aversion. Simple measures to reduce the speed with which investors can redeem investments
can reduce the extent of yield dislocation. We also explore the impact of the growth in passive investment,
and find that it increases the tail risk of big yield dislocations after shocks, though, on average,
volatility may be reduced. This highlights the importance of the interaction between trading behaviour
and market maker response, suggesting that measures to reduce the risk of momentum trading in a shock
such as disclosure may help mitigate the risk of overshoots in price adjustments.