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Does the liquidity effect guarantee a positive term premium?

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  • Chung, Kyuil

Abstract

This paper examines the liquidity effect and the term structure in two versions of the limited participation model--an imperfect information model and an adjustment cost model. With a discrete-state solution approach, I find a striking contrast: while the imperfect information model successfully generates the liquidity effect and the positive term premium seen in the data; the adjustment cost model replicates only the liquidity effect. This is because the adjustment cost that drives the liquidity effect in the adjustment cost model also creates an adjustment cost effect, which leads to a negative term premium.

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  • Chung, Kyuil, 2009. "Does the liquidity effect guarantee a positive term premium?," Economic Modelling, Elsevier, vol. 26(5), pages 893-903, September.
    • Handle: RePEc:eee:ecmode:v:26:y:2009:i:5:p:893-903
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