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Liquidity-adjusted benchmark yield curves: a look at trading concentration and information

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  • Lin, William
  • Sun, David

Abstract

Estimation of benchmark yield curve in developing markets is often influenced by liquidity concentration. Based on an affine term structure model, we develop a long run liquidity weighted fitting method to address the trading concentration phenomenon arising from horizon-induced clientele equilibrium as well as information discovery. Specifically, we employ arguments from models of liquidity concentration and benchmark security information. After examining time series behavior of price errors against our fitted model, we find results consistent with both the horizon and information hypotheses. Our evidence indicates that trading liquidity carries information effect in the long run, which cannot be fully captured in the short run. Trading liquidity plays a key role in long run term structure fitting. Markets for liquid benchmark government bond issues collectively form a long term equilibrium. Compared with previous studies, our results provide a robust and realistic characterization of the spot rate term structure and related price forecasting over time, which in turn help portfolio investment of fixed income and long run pricing of financial instruments.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 37282.

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Date of creation: Dec 2007
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Publication status: Published in Review of Pacific Basin Financial Markets and Policies 10.4(2007): pp. 491-518
Handle: RePEc:pra:mprapa:37282

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Keywords: liquidity; trading concentration; information discovery; term structure; yield curve;

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  1. Shiller, Robert J. & Huston McCulloch, J., 1990. "The term structure of interest rates," Handbook of Monetary Economics, Elsevier, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 1, chapter 13, pages 627-722 Elsevier.
  2. Diebold, Francis X. & Li, Canlin, 2003. "Forecasting the term structure of government bond yields," CFS Working Paper Series 2004/09, Center for Financial Studies (CFS).
  3. Nelson, Charles R & Siegel, Andrew F, 1987. "Parsimonious Modeling of Yield Curves," The Journal of Business, University of Chicago Press, vol. 60(4), pages 473-89, October.
  4. Bolder, David & Streliski, David, 1999. "Yield Curve Modelling at the Bank of Canada," Technical Reports, Bank of Canada 84, Bank of Canada.
  5. Michael J. Fleming, 2003. "Measuring treasury market liquidity," Economic Policy Review, Federal Reserve Bank of New York, Federal Reserve Bank of New York, issue Sep, pages 83-108.
  6. Edwin J. Elton & T. Clifton Green, 1998. "Tax and Liquidity Effects in Pricing Government Bonds," Journal of Finance, American Finance Association, American Finance Association, vol. 53(5), pages 1533-1562, October.
  7. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, American Finance Association, vol. 57(1), pages 405-443, 02.
  8. Diaz, Antonio & Merrick, John Jr. & Navarro, Eliseo, 2006. "Spanish Treasury bond market liquidity and volatility pre- and post-European Monetary Union," Journal of Banking & Finance, Elsevier, Elsevier, vol. 30(4), pages 1309-1332, April.
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