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Does the liquidity effect guarantee a positive term premium?

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  • Chung, Kyuil
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    Abstract

    This paper examines the liquidity effect and the term structure in two versions of the limited participation model--an imperfect information model and an adjustment cost model. With a discrete-state solution approach, I find a striking contrast: while the imperfect information model successfully generates the liquidity effect and the positive term premium seen in the data; the adjustment cost model replicates only the liquidity effect. This is because the adjustment cost that drives the liquidity effect in the adjustment cost model also creates an adjustment cost effect, which leads to a negative term premium.

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    Bibliographic Info

    Article provided by Elsevier in its journal Economic Modelling.

    Volume (Year): 26 (2009)
    Issue (Month): 5 (September)
    Pages: 893-903

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    Handle: RePEc:eee:ecmode:v:26:y:2009:i:5:p:893-903

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    Web page: http://www.elsevier.com/locate/inca/30411

    Related research

    Keywords: Term premium The liquidity effect Limited participation model;

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