Skip to main content Accessibility help
×
×
Home

How Does Liquidity Affect Government Bond Yields?

  • Carlo Favero (a1), Marco Pagano (a2) and Ernst-Ludwig von Thadden (a3)
Abstract

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.

Copyright
References
Hide All
Acharya, V. V., and Pedersen, L. H.. “Asset Pricing with Liquidity Risk.” Journal of Financial Economics, 77 (2005), 375410.
Amihud, Y., and Mendelson, H.. “Asset Pricing and the Bid-Ask Spread.” Journal of Financial Economics, 17 (1986), 223249.
Amihud, Y., and Mendelson, H.. “Liquidity, Maturity, and the Yields on U.S. Treasury Securities.” Journal of Finance, 46 (1991), 14111425.
Arora, V., and Cerisola, M.. “How Does U.S. Monetary Policy Influence Sovereign Spreads in Emerging Markets?IMF Staff Papers, 48 (2001), 474498.
Barnes, K., and Cline, W.. “Spreads and Risks in Emerging Markets Lending.” Working Paper No. 97–1, Institute of International Finance (1997).
Beber, A.; Brandt, M. W.; and Kavajecz, K. A.. “Flight-to-Quality or Flight-to-Liquidity? Evidence from the Euro-Area Bond Market.” Review of Financial Studies, 22 (2009), 925957.
Blanco, R. “The Euro-Area Government Securities Markets: Recent Developments and Implications for Market Functioning.” Servicio de Estudios Working Paper 0120, Banco de España (2001).
Brennan, M. J., and Subrahmanyam, A.. “Market Microstructure and Asset Pricing: On the Compensation for Illiquidity in Stock Returns.” Journal of Financial Economics, 41 (1996), 441464.
Chordia, T.; Roll, R.; and Subrahmanyam, A.. “Market Liquidity and Trading Activity.” Journal of Finance, 56 (2000), 501530.
Codogno, L.; Favero, C.; and Missale, A.. “Yield Spreads on EMU Government Bonds.” Economic Policy, 18 (2003), 503532.
Cox, J.; Ingersoll, J.; and Ross, S.. “A Theory of the Term Structure of Interest Rates.” Econometrica, 53 (1985), 385407.
Datar, V. T.; Naik, N. Y.; and Radcliffe, R.. “Liquidity and Stock Returns: An Alternative Test.” Journal of Financial Markets, 1 (1998), 203219.
Daves, P. R., and Ehrhardt, M. C.. “Liquidity, Reconstitution, and the Value of U.S. Treasury Strips.” Journal of Finance, 48 (1993), 315329.
Diamond, D. W., and Dybvig, P. H.. “Bank Runs, Deposit Insurance, and Liquidity.” Journal of Political Economy, 91 (1983), 401419.
Duffee, G. R. “The Relation between Treasury Yields and Corporate Bond Yield Spreads.” Journal of Finance, 53 (1998), 22252241.
Duffie, D., and Huang, M.. “Swap Rates and Credit Quality.” Journal of Finance, 51 (1996), 921949.
Dungey, M.; Martin, V. L.; and Pagan, A. R.. “A Multivariate Latent Factor Decomposition of International Bond Yield Spreads.” Journal of Applied Econometrics, 15 (2000), 697715.
Dunne, P. G.; Moore, M. J.; and Portes, R.. “Benchmark Status in Fixed-Income Asset Markets.” Journal of Business Finance and Accounting, 34 (2007), 16151634.
Eichengreen, B., and Mody, A.. “What Explains Changing Spreads on Emerging Market Debt?” In Capital Flows and the Emerging Economies: Theory, Evidence, and Controversies, Edwards, S. ed., NBER Conference Report series. Chicago and London: University of Chicago Press (2000).
Ellul, A., and Pagano, M.. “IPO Underpricing and After-Market Liquidity.” Review of Financial Studies, 19 (2006), 381421.
Ericsson, J., and Renault, O.. “Liquidity and Credit Risk.” Journal of Finance, 61 (2006), 22192250.
Gallmeyer, M.; Hollifield, B.; and Seppi, D.. “Demand Discovery and Asset Pricing.” Working Paper, Carnegie Mellon University (2006).
Geyer, A.; Kossmeier, S.; and Pichler, S.. “Measuring Systematic Risk in EMU Government Yield Spreads.” Review of Finance, 8 (2004), 171197.
Goldreich, D.; Hanke, B.; and Nath, P.. “The Price of Future Liquidity: Time-Varying Liquidity in the U.S. Treasury Market.” Review of Finance, 9 (2005), 132.
Kamara, A. “Liquidity, Taxes, and Short-Term Treasury Yields.” Journal of Financial and Quantitative Analysis, 29 (1994), 403417.
Kamin, S. B., and Von Kleist, K.. “The Evolution and Determinants of Emerging Market Credit Spreads in the 1990s.” International Finance Discussion Papers 653. Washington, DC: Board of Governors of the Federal Reserve System (1999).
Krishnamurthy, A. “The Bond/Old-Bond Spread.” Journal of Financial Economics, 66 (2002), 463506.
Longstaff, F. A.; Mithal, S.; and Neis, E.. “Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market.” Journal of Finance, 55 (2005), 22132253.
Merton, R. C.Optimum Consumption and Portfolio Rules in a Continuous-Time Model.” Journal of Economic Theory, 3 (1971), 373413.
Moskowitz, T. J., and Vissing-Jorgensen, A.. “The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle?American Economic Review, 92 (2002), 745778.
Pagano, M., and von Thadden, E.. “The European Bond Markets under EMU.” Oxford Review of Economic Policy, 20 (2004), 531554.
Pástor, L., and Stambaugh, R. F.. “Liquidity Risk and Expected Stock Returns.” Journal of Political Economy, 111 (2003), 642685.
Strebulaev, I.“Liquidity and Asset Pricing: Evidence from the U.S. Treasury Securities Market.” Working Paper, Stanford University (2003).
Vayanos, D. “Flight to Quality, Flight to Liquidity, and the Pricing of Risk.” NBER Working Paper No. 10327 (2004).
Warga, A.Bond Returns, Liquidity, and Missing Data.” Journal of Financial and Quantitative Analysis, 27 (1992), 605617.
Recommend this journal

Email your librarian or administrator to recommend adding this journal to your organisation's collection.

Journal of Financial and Quantitative Analysis
  • ISSN: 0022-1090
  • EISSN: 1756-6916
  • URL: /core/journals/journal-of-financial-and-quantitative-analysis
Please enter your name
Please enter a valid email address
Who would you like to send this to? *
×

Metrics

Full text views

Total number of HTML views: 0
Total number of PDF views: 0 *
Loading metrics...

Abstract views

Total abstract views: 0 *
Loading metrics...

* Views captured on Cambridge Core between <date>. This data will be updated every 24 hours.

Usage data cannot currently be displayed