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How important is liquidity risk for sovereign bond risk premia? Evidence from the London stock exchange

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  • Alquist, Ron

Abstract

Using a unique data set, this paper studies the relationship between market liquidity risk and sovereign bond risk premia. The London Stock Exchange during the late 19th century is an ideal laboratory in which to examine the effect of market liquidity on sovereign bond prices. This period was the last time when the debt of a heterogeneous set of countries was traded in a centralized location and for which sufficiently long time series of observable bond prices are available to conduct asset-pricing tests. Empirical analysis of these data establishes two results. First, illiquid sovereign bonds carry larger factor loadings on market liquidity than liquid bonds. The difference in average excess returns is not only due to the larger transaction costs associated with holding illiquid bonds but also to the greater sensitivity of the returns of illiquid bonds to fluctuations in market liquidity. Second, excess bond returns are linearly related to the returns of a liquidity-mimicking portfolio in the cross-section, indicating that market liquidity is a priced common risk factor. At about 2.8% per year, the price for bearing liquidity risk is economically significant. Overall, this evidence underscores the importance of understanding the effect of market liquidity on bond prices, even in an economic environment that seems remote from today's.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of International Economics.

Volume (Year): 82 (2010)
Issue (Month): 2 (November)
Pages: 219-229

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Handle: RePEc:eee:inecon:v:82:y:2010:i:2:p:219-229

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Web page: http://www.elsevier.com/locate/inca/505552

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Keywords: Sovereign bond returns Market liquidity Liquidity risk factor Country risk premium;

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Cited by:
  1. Richard C.K. Burdekin & Kris James Mitchener & Marc D. Weidenmier, 2012. "Irving Fisher and Price‐Level Targeting in Austria: Was Silver the Answer?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(4), pages 733-750, 06.
  2. Flandreau, Marc & Oosterlinck, Kim, 2012. "Was the emergence of the international gold standard expected? Evidence from Indian Government securities," Journal of Monetary Economics, Elsevier, vol. 59(7), pages 649-669.

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