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How Does Liquidity Affect Government Bond Yields?

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 Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy in its series CSEF Working Papers with number 181.

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Date of creation: 01 Jun 2007
Date of revision:
Publication status: published in the Journal of Financial and Quantitative Analysis, Vol. 45, No. 1, February 2010, 107-134
Handle: RePEc:sef:csefwp:181
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