Limits to Arbitrage: Empirical Evidence from Euro Area Sovereign Bond Markets

We document that the yield-to-maturity of an USD-denominated bond, once the foreign exchange rate risk is hedged, could be higher by more than 150 basis points than a comparable EUR-denominated bond issued by the same Euro area country between 2008-2013. Using panel and matching techniques, we find that the pricing anomaly (i) is due to the lower haircuts applied to EUR-denominated bonds for the European Central Bank (ECB) liquidity operations; (ii) is strongly positively related to the amount of EUR-denominated bonds pledged in exchange for liquidity when the credit spreads of the sovereign issuer reach extreme levels; (iii) is strongly positively related to the amount of EUR-denominated sovereign bonds pledged in exchange for liquidity with a 3-year horizon; and (iv) widens during the ECB purchases of EUR-denominated bonds.