Freeze and Bid-Ask Spread in the Sovereign Bond Market

Abstract

We describe a model for two market-makers in the sovereign bond market. The paper gives special importance to the way payments are decided and reflects the cost of securities issuance and trading, a usually small and neglected component of the bond price in normal times. The model generates a dynamic of the bid-ask spread which depends on the discount rate of utility of the market-makers. The novelty of the paper consists in modelling the discount rate of utility as a function depending on fundamentals and the possible changes in the overall risk aversion in the market. The latter aspect is modelled as a martingale process and called sentiment process. We then obtain a solution for our model that can qualitatively mimic the decrease of turnover and the related increase of spread observed in periods of financial uncertainty.