Bond Lending and the Law of One Price in China's Treasury Markets

Abstract

This paper examines how the introduction of bond lending in China's bond market has affected violations of the law of one price, measured by the yield spread between similar treasury bonds. To identify the effect of bond lending, we exploit the fact that in China identical bonds are traded on two segmented markets and bond lending has been introduced in only one of the two markets. We find that the introduction of bond lending has led to a decline in deviations from the law of one price. Consistent with an interpretation based on limits to arbitrage, a significant fraction of the deviations from the law of one price in our sample represent actual profit opportunities and the introduction of bond lending has reduced arbitrage profits.