Abstract
In this paper, we introduce a small-scale heterogeneous agent-based model of the US corporate bond market. The model includes a realistic micro-grounded ecology of investors that trade a set of bonds through dealers. Using the model, we simulate market dynamics that emerge from agent behaviors in response to basic exogenous factors (such as interest rate shocks) and the introduction of regulatory policies and constraints. A first experiment focuses on the liquidity transformation provided by mutual funds and investigates the conditions under which redemption-driven bond sales may trigger market instability. We simulate the effects of increasing mutual fund market shares in the presence of market-wide repricing of risk (in the form of a 100 basis point increase in the expected returns). The simulations highlight robust-yet-fragile aspects of the growing liquidity transformation provided by mutual funds, with an inflection point beyond which redemption-driven negative feedback loops trigger market instability.
Highlights
The financial crisis of 2008 again highlighted the complex and evolving nature of the financial system and spurred another round of research into the dynamics of financial crises
Using the model setup outlined above, we simulate the effect of a 100 basis point rise in expected yields under various mutual fund market shares
In a research note focused on the first mover advantage in high-yield bond mutual funds, Barclays analysts investigate a variety of market shocks, with the most adverse case amounting to a 10% market drop, about 3% higher than the market correction used in our simulation
Summary
The financial crisis of 2008 again highlighted the complex and evolving nature of the financial system and spurred another round of research into the dynamics of financial crises. New regulations aimed to curb risk taking in areas that were at the center of the crisis and limit the potential for contagion to other financial industry segments (with institutions deemed too-big-to-fail being a primary concern). That the financial industry tends to respond to regulation by re-allocating risks across the system. Crises tend to originate in new areas and rarely copy historical patterns. In the years following the crisis, credit provision to the corporate sector witnessed significant changes.
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