How Does Liquidity Affect Government Bond Yields?
AbstractThe paper explores 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 aggregate risk. In contrast, liquidity differentials display sizeable heterogeneity and no common factor. We propose a simple model with endogenous liquidity demand, where a bond’s liquidity premium depends both on its transaction cost and on investment opportunities. The model predicts that yield differentials should increase in both liquidity and risk, with an interaction term of the opposite sign. Testing these predictions on daily data, we find that the aggregate risk factor is consistently priced, liquidity differentials are priced for a subset of countries, and their interaction with the risk factor is in line with the model’s prediction and crucial to detect their effect.
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Bibliographic InfoPaper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 323.
Date of creation: 2007
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Other versions of this item:
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- J12 - Labor and Demographic Economics - - Demographic Economics - - - Marriage; Marital Dissolution; Family Structure
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-06-11 (All new papers)
- NEP-EEC-2007-06-11 (European Economics)
- NEP-MAC-2007-06-11 (Macroeconomics)
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