Asset Mispricing

Read Time - 10 min

The law of one price states that assets with the same payoff have the same price. Although this no arbitrage condition appears to be satisfied most of the time, a growing literature reveals cases whereby this condition has been violated, thus potentially resulting in arbitrage opportunities. In this paper, the authors use a unique data set of corporate bonds explicitly guaranteed by the full faith and credit of the U.S. to explore the law of one price in the corporate bond market. They find significant and persistent mispricing of the guaranteed corporate bonds over time and across bonds. The authors then use this data set to explore a number of practical theories about why prices might diverge from their fundamental values.

A central tenet of modern financial theory is that the price of a security should equal the present value of its cash flows; that is, its fundamental value. This means that assets with the same fundamental value should trade at the same price within or across markets. However, the law of one price concept has been challenged by examples of assets prices that seemingly diverge from their fundamental value, especially during, but not limited to, financial crises and major market events. Such deviations are important because they may lead to arbitrage opportunities, but equally important is that they provide researchers with an opportunity to better understand the conditions that may give rise to them.  Asset mispricing could be a reflection of broader macro issues, for instance, or funding or capital constraints faced by the institutions that own or trade the assets. Or perhaps there are some micro issues related to specific characteristics of the assets in question that are driving mispricing.

Seeking to gain such insights into the reasons for market mispricing, the authors explore a unique dataset that focuses on corporate bonds that were issued under an explicit debt guarantee program administered by the Federal Deposit Insurance Corporation (FDIC).  They then compare the yields on these U.S. government guaranteed corporate bonds with those of comparable U.S. Treasury bonds, which of course are also guaranteed by the full faith and credit of the U.S. This then facilitates an accurate price comparison between two types of bonds with the same cash flows (identical coupon and maturity date) and credit risk. Any price deviations from Treasury bonds (the yield spread does not equal to zero) means the law of one price has been violated. Over the sample period 2008-2012, they document significant and persistent mispricing averaging 20 basis points with dramatic variation in the amount of mispricing over time and across bonds.

The literature points to several possible drivers of deviations from fundamental value including intermediary capital, funding liquidity, slow-moving capital, and liquidity effects. To understand whether these drivers may be behind any observed mispricings, the authors’ database also provides information on intermediary funding costs and haircuts, dealer networks and inventory positions, trading and positions of non-dealer financial institutions, and various liquidity measures. A number of important lessons about asset pricing are drawn from exploring these potential drivers.

  • The evidence suggests that their observed deviations from fundamental values may represent an important source of systematic risk in the financial markets as evidenced by a high degree of commonality in the observed mispricings. Furthermore, these deviations may actually have toxic effects on markets through a destabilizing impact on margins and dealer funding costs.
  • There is a positive relation between mispricing and dealer funding costs, meaning that capital constraints may play an important role in asset pricing.
  • Results suggest that asset prices may be driven by forces that are unrelated to either cash flows or discount rates, a finding at odds with the law of one price that dictates asset prices should be equal to the present value of their cash flows.

Using a unique data set of corporate bonds explicitly backed by the U.S., the authors add to the growing roster of cases whereby asset prices diverge from fundamental value. Their results provide practical evidence for theoretical models that suggest disruptions to intermediary funding costs and capacity lead to violations of the law of one price in markets. Asset prices can therefore be driven by common factors such as margin constraints unrelated to cash flows and discount rates may be destabilizing and thus represent an important source of systematic market risk to investors. For instance, increases in market mispricing may lead to margin and funding spirals.

This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. 

This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. 

The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.