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Valutation, Liquidity and Risk in Government Bond Markets

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  • Carlo Favero
  • Marco Pagano
  • Ernst-Ludwig von Thadden

Abstract

We explore the determinants of yield differentials between sovereign bonds in the Euro area. There is a common trend in yield differentials, which is correlated with a measure of the international risk factor. In contrast, liquidity differentials display sizeable heterogeneity and no common factor. We present a model that predicts that yield differentials should increase in both liquidity and risk, with an interaction term whose magnitude and sign depends on the size of the liquidity differential with respect to the reference country. Testing these predictions on daily data, we find that the international risk factor is consistently priced, while liquidity differentials are priced only for a subset of countries and their interaction with the risk factor is crucial to detect their effect.

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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 281.

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Date of creation: 2005
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Handle: RePEc:igi:igierp:281

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Cited by:
  1. Faruk Balli, 2009. "Spillover effects on government bond yields in euro zone. Does full financial integration exist in European government bond markets?," Journal of Economics and Finance, Springer, Springer, vol. 33(4), pages 331-363, October.
  2. Sebastian Weber, 2009. "European Financial Market Integration: A Closer Look at Government Bonds in Eurozone Countries," Working Paper / FINESS, DIW Berlin, German Institute for Economic Research 1.1b, DIW Berlin, German Institute for Economic Research.
  3. Menkveld, Albert J. & Cheung, Yiu C. & Jong, Frank de, 2006. "Euro-Area Sovereign Yield Dynamics: the role of order imbalance," Serie Research Memoranda, VU University Amsterdam, Faculty of Economics, Business Administration and Econometrics 0006, VU University Amsterdam, Faculty of Economics, Business Administration and Econometrics.
  4. Coluzzi, Chiara & Ginebri, Sergio & Turco, Manuel, 2008. "Measuring and Analyzing the Liquidity of the Italian Treasury Security Wholesale Secondary Market," Economics & Statistics Discussion Papers esdp08044, University of Molise, Dept. EGSeI.
  5. Schuknecht, Ludger & von Hagen, Jürgen & Wolswijk, Guido, 2007. "Government Risk Premiums in the Bond Market: EMU and Canada," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6579, C.E.P.R. Discussion Papers.
  6. Marta Gómez-Puig, 2007. "EU-15 sovereign governments' cost of borrowing after seven years of Monetary Union," Working Papers, Asociación Española de Economía y Finanzas Internacionales 07-03, Asociación Española de Economía y Finanzas Internacionales.

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