N°17-32: The Sovereign Debt Crisis: Flights or Freezes?

Multiple asset pricing theories predict that large price changes should be associated with abnormal trading volume, inducing investor rebalancing and possibly leading to flights. In contrast, consistent with market microstructure theories, this paper documents freezes, a reduction in trading volume of (approximately 30% relative to the previous trading week) during market stress episodes in the European sovereign bond market. We show that the effect of price changes on trading volume is highly state contingent, rebalancing occurs in normal times and freezes in crisis times. We trace the market freezes to increasing transaction costs driven by reduced risk bearing capacity of market makers.