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How Does Liquidity Affect Government Bond Yields?

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

The paper explores the determinants of yield differentials between sovereign bonds, using euro-area data. 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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Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 45 (2010)
Issue (Month): 01 (February)
Pages: 107-134

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Handle: RePEc:cup:jfinqa:v:45:y:2010:i:01:p:107-134_99
Contact details of provider: Postal: Cambridge University Press, UPH, Shaftesbury Road, Cambridge CB2 8BS UK
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