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A Liquidity Premium Puzzle?: Evidence from Chile

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  • Viviana Fernández

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Abstract

This article looks at the determinants of liquidity premium of the term structure of interest rates. Based upon a very simple model, we show that liquidity premium is not necessarily positive, as usually believed. This point is illustrated empirically with Chilean data for the sample period 1983-1999. Our estimation results show that liquidity premium is not only time-varying but that it also depends on the curvature of the term structure, expected inflation, expected depreciation of the nominal exchange rate, and on economic activity, contradicting the expectations hypothesis. For our sample period, the liquidity premium is usually negative, and when positive it is very small. This implies that investors are willing to hold long-term assets even though their return is relatively lower. This appears to be a consequence of indexation, which reduces the risk of long-term bonds as their return is linked to past inflation. Alternatively, we believe that a negative liquidity premium may be explained by the preferred habitat hypothesis of interest rates. Indeed, data on the composition of the portfolios of Chilean insurance and re-insurance companies show that, due to immunization (matching of durations of assets and liabilities), about a 60 percent of total assets correspond with long-term bonds and mortgage securities. This investment strategy drives the prices of long-term financial instruments up, and their rates down.

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Bibliographic Info

Paper provided by Centro de Economía Aplicada, Universidad de Chile in its series Documentos de Trabajo with number 105.

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Date of creation: 2001
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Handle: RePEc:edj:ceauch:105

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  1. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, vol. 47(3), pages 1209-27, July.
  2. Martin D. Evans, 1992. "Expected Returns, Time-Varying Risk and Risk Premia," Working Papers 92-14, New York University, Leonard N. Stern School of Business, Department of Economics.
  3. N. Gregory Mankiw & Lawrence H. Summers, 1984. "Do Long-Term Interest Rates Overreact to Short-Term Interest Rates?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 15(1), pages 223-248.
  4. Engle, Robert F & Ng, Victor K, 1993. " Measuring and Testing the Impact of News on Volatility," Journal of Finance, American Finance Association, vol. 48(5), pages 1749-78, December.
  5. Flannery, Mark J. & Hameed, Allaudeen S. & Harjes, Richard H., 1997. "Asset pricing, time-varying risk premia and interest rate risk," Journal of Banking & Finance, Elsevier, vol. 21(3), pages 315-335, March.
  6. Shiller, Robert J, 1979. "The Volatility of Long-Term Interest Rates and Expectations Models of the Term Structure," Journal of Political Economy, University of Chicago Press, vol. 87(6), pages 1190-1219, December.
  7. Robert J. Shiller & John Y. Campbell & Kermit L. Schoenholtz, 1983. "Forward Rates and Future Policy: Interpreting the Term Structure of Interest Rates," Cowles Foundation Discussion Papers 667, Cowles Foundation for Research in Economics, Yale University.
  8. Fernando Lefort G. & Eduardo Walker H., 2000. "The Structure of Real Interest Rates in Chile," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 3(2), pages 31-52, August.
  9. Hyytinen, Ari, 1999. "Stock Return Volatility on Scandinavian Stock Markets and the Banking Industry," Research Discussion Papers 19/1999, Bank of Finland.
  10. Claudio Soto & Rodrigo Valdés, 1999. "Exchange Volatility and Risk Premium," Working Papers Central Bank of Chile 46, Central Bank of Chile.
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