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How Does Liquidity Affect Government Bond Yields?

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Author Info
Carlo Favero
Marco Pagano
Ernst-Ludwig von Thadden

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Abstract

The 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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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 323.

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Date of creation: 2007
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Handle: RePEc:igi:igierp:323

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  1. Acharya, Viral V & Pedersen, Lasse Heje, 2004. "Asset Pricing with Liquidity Risk," CEPR Discussion Papers 4718, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  2. Tobias J. Moskowitz & Annette Vissing-Jørgensen, 2002. "The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle?," American Economic Review, American Economic Association, vol. 92(4), pages 745-778, September. [Downloadable!]
  3. Burton Hollifield & Michael Gallmeyer & Duane Seppi, 2004. "Liquidity Discovery and Asset Pricing," 2004 Meeting Papers 136a, Society for Economic Dynamics. [Downloadable!]
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  4. Brennan, Michael J. & Subrahmanyam, Avanidhar, 1996. "Market microstructure and asset pricing: On the compensation for illiquidity in stock returns," Journal of Financial Economics, Elsevier, vol. 41(3), pages 441-464, July. [Downloadable!] (restricted)
  5. Duffie, Darrell & Huang, Ming, 1996. " Swap Rates and Credit Quality," Journal of Finance, American Finance Association, vol. 51(3), pages 921-49, July. [Downloadable!] (restricted)
  6. Pagano, Marco & von Thadden, Ernst-Ludwig, 2004. "The European Bond Markets Under EMU," CEPR Discussion Papers 4779, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  7. Pastor, Lubos & Stambaugh, Robert F., 2003. "Liquidity Risk and Expected Stock Returns," Journal of Political Economy, University of Chicago Press, vol. 111(3), pages 642-685, June. [Downloadable!] (restricted)
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  8. Andrew Ellul & Marco Pagano, 2003. "IPO underpricing and after-market liquidity," CSEF Working Papers 99, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy. [Downloadable!]
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  9. Jan Ericsson & Olivier Renault, 2006. "Liquidity and Credit Risk," Journal of Finance, American Finance Association, vol. 61(5), pages 2219-2250, October. [Downloadable!] (restricted)
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  10. Daves, Phillip R & Ehrhardt, Michael C, 1993. " Liquidity, Reconstitution, and the Value of U.S. Treasury Strips," Journal of Finance, American Finance Association, vol. 48(1), pages 315-29, March. [Downloadable!] (restricted)
  11. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June. [Downloadable!] (restricted)
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  12. Warga, Arthur, 1992. "Bond Returns, Liquidity, and Missing Data," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 27(04), pages 605-617, December. [Downloadable!]
  13. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December. [Downloadable!] (restricted)
  14. Anat R. Admati, Paul Pfleiderer, 1988. "A Theory of Intraday Patterns: Volume and Price Variability," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 1(1), pages 3-40. [Downloadable!] (restricted)
  15. Barry Eichengreen & Ashoka Mody, 2000. "What Explains Changing Spreads on Emerging Market Debt?," NBER Chapters, in: Capital Flows and the Emerging Economies: Theory, Evidence, and Controversies, pages 107-136 National Bureau of Economic Research, Inc. [Downloadable!]
  16. Dimitri Vayanos, 2004. "Flight to Quality, Flight to Liquidity, and the Pricing of Risk," NBER Working Papers 10327, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  17. Datar, Vinay T. & Y. Naik, Narayan & Radcliffe, Robert, 1998. "Liquidity and stock returns: An alternative test," Journal of Financial Markets, Elsevier, vol. 1(2), pages 203-219, August. [Downloadable!] (restricted)
  18. Alois Geyer & Stephan Kossmeier & Stefan Pichler, 2004. "Measuring Systematic Risk in EMU Government Yield Spreads," Review of Finance, Springer, vol. 8(2), pages 171-197. [Downloadable!]
  19. Tobias J. Moskowitz & Annette Vissing-Jorgensen, 2002. "The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle?," NBER Working Papers 8876, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  20. Mardi Dungey & Vance L Martin & Adrian R Pagan, 2000. "A multivariate latent factor decomposition of international bond yield spreads," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 15(6), pages 697-715. [Downloadable!]
  21. Kamara, Avraham, 1994. "Liquidity, Taxes, and Short-Term Treasury Yields," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(03), pages 403-417, September. [Downloadable!]
  22. Amihud, Yakov & Mendelson, Haim, 1991. " Liquidity, Maturity, and the Yields on U.S. Treasury Securities," Journal of Finance, American Finance Association, vol. 46(4), pages 1411-25, September. [Downloadable!] (restricted)
  23. Dunne, Peter & Moore, Michael J & Portes, Richard, 2002. "Defining Benchmark Status: An Application using Euro-Area Bonds," CEPR Discussion Papers 3490, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  24. Krishnamurthy, Arvind, 2002. "The bond/old-bond spread," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 463-506. [Downloadable!] (restricted)
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Schulz, Alexander & Wolff, Guntram B., 2009. "Sovereign bond market integration: the euro, trading platforms and financial crises," MPRA Paper 16900, University Library of Munich, Germany. [Downloadable!]
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This page was last updated on 2009-11-23.

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