Working Paper No. 592
By Karen Braun-Munzinger, Zijun Liu and Arthur Turrell
We construct a heterogeneous agent-based 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 strongly influence the over and undershooting of yields in response to a shock. This suggests that correlation in funds’ trading strategies can exacerbate extreme price movements and contribute to the procyclicality of financial markets. 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.