Dislocation

Abstract

Price dislocations are common in fixed-income markets. I propose a dislocation factor (DIS), the first principle of three fixed-income market dislocations, including covered interest parity, on/off the run spread, and treasury noise measure. DIS surges when the market is under stress and indicates broad market conditions such as liquidity, volatility, and credit. DIS has insights for understanding asset prices both in time series and cross-section. In the time series, DIS has both explanatory and predictive power for the performance of equity long-short strategies: high DIS is usually followed by lower return and higher co-movement. In the cross-section, DIS is a priced risk factor and helps explain the return variation: more negative exposure to DIS results in a higher average return, compensating correlated risks.