Hostname: page-component-745bb68f8f-5r2nc Total loading time: 0 Render date: 2025-01-27T03:56:04.817Z Has data issue: false hasContentIssue false
  • English
  • Français

How Does Liquidity Affect Government Bond Yields?

Published online by Cambridge University Press:  26 November 2009

Carlo Favero ,
Marco Pagano  and
Ernst-Ludwig von Thadden
Carlo Favero
Affiliation:
Università Bocconi, IGIER, Università Commerciale Luigi Bocconi, Via Salasco 5, 20136 Milan, Italy. [email protected]
Marco Pagano
Affiliation:
Department of Economics, Università di Napoli Federico II, Via Cintia, 80126 Naples, Italy. [email protected]
Ernst-Ludwig von Thadden
Affiliation:
Department of Economics, Universität Mannheim, L 7,3-5, 68131 Mannheim, Germany. [email protected]
Get access Rights & Permissions [Opens in a new window]

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.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 1 , February 2010 , pp. 107 - 134
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Acharya, V. V., and Pedersen, L. H.. “Asset Pricing with Liquidity Risk.” Journal of Financial Economics, 77 (2005), 375–410.CrossRefGoogle Scholar
Amihud, Y., and Mendelson, H.. “Asset Pricing and the Bid-Ask Spread.” Journal of Financial Economics, 17 (1986), 223–249.CrossRefGoogle Scholar
Amihud, Y., and Mendelson, H.. “Liquidity, Maturity, and the Yields on U.S. Treasury Securities.” Journal of Finance, 46 (1991), 1411–1425.CrossRefGoogle Scholar
Arora, V., and Cerisola, M.. “How Does U.S. Monetary Policy Influence Sovereign Spreads in Emerging Markets?” IMF Staff Papers, 48 (2001), 474–498.Google Scholar
Barnes, K., and Cline, W.. “Spreads and Risks in Emerging Markets Lending.” Working Paper No. 97–1, Institute of International Finance (1997).Google Scholar
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), 925–957.CrossRefGoogle Scholar
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).Google Scholar
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), 441–464.CrossRefGoogle Scholar
Chordia, T.; Roll, R.; and Subrahmanyam, A.. “Market Liquidity and Trading Activity.” Journal of Finance, 56 (2000), 501–530.CrossRefGoogle Scholar
Codogno, L.; Favero, C.; and Missale, A.. “Yield Spreads on EMU Government Bonds.” Economic Policy, 18 (2003), 503–532.CrossRefGoogle Scholar
Cox, J.; Ingersoll, J.; and Ross, S.. “A Theory of the Term Structure of Interest Rates.” Econometrica, 53 (1985), 385–407.Google Scholar
Datar, V. T.; Naik, N. Y.; and Radcliffe, R.. “Liquidity and Stock Returns: An Alternative Test.” Journal of Financial Markets, 1 (1998), 203–219.CrossRefGoogle Scholar
Daves, P. R., and Ehrhardt, M. C.. “Liquidity, Reconstitution, and the Value of U.S. Treasury Strips.” Journal of Finance, 48 (1993), 315–329.CrossRefGoogle Scholar
Diamond, D. W., and Dybvig, P. H.. “Bank Runs, Deposit Insurance, and Liquidity.” Journal of Political Economy, 91 (1983), 401–419.CrossRefGoogle Scholar
Duffee, G. R. “The Relation between Treasury Yields and Corporate Bond Yield Spreads.” Journal of Finance, 53 (1998), 2225–2241.Google Scholar
Duffie, D., and Huang, M.. “Swap Rates and Credit Quality.” Journal of Finance, 51 (1996), 921–949.CrossRefGoogle Scholar
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), 697–715.CrossRefGoogle Scholar
Dunne, P. G.; Moore, M. J.; and Portes, R.. “Benchmark Status in Fixed-Income Asset Markets.” Journal of Business Finance and Accounting, 34 (2007), 1615–1634.Google Scholar
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).Google Scholar
Ellul, A., and Pagano, M.. “IPO Underpricing and After-Market Liquidity.” Review of Financial Studies, 19 (2006), 381–421.CrossRefGoogle Scholar
Ericsson, J., and Renault, O.. “Liquidity and Credit Risk.” Journal of Finance, 61 (2006), 2219–2250.Google Scholar
Gallmeyer, M.; Hollifield, B.; and Seppi, D.. “Demand Discovery and Asset Pricing.” Working Paper, Carnegie Mellon University (2006).Google Scholar
Geyer, A.; Kossmeier, S.; and Pichler, S.. “Measuring Systematic Risk in EMU Government Yield Spreads.” Review of Finance, 8 (2004), 171–197.CrossRefGoogle Scholar
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), 1–32.CrossRefGoogle Scholar
Kamara, A. “Liquidity, Taxes, and Short-Term Treasury Yields.” Journal of Financial and Quantitative Analysis, 29 (1994), 403–417.Google Scholar
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).CrossRefGoogle Scholar
Krishnamurthy, A. “The Bond/Old-Bond Spread.” Journal of Financial Economics, 66 (2002), 463–506.Google Scholar
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), 2213–2253.CrossRefGoogle Scholar
Merton, R. C. “Optimum Consumption and Portfolio Rules in a Continuous-Time Model.” Journal of Economic Theory, 3 (1971), 373–413.CrossRefGoogle Scholar
Moskowitz, T. J., and Vissing-Jorgensen, A.. “The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle?” American Economic Review, 92 (2002), 745–778.CrossRefGoogle Scholar
Pagano, M., and von Thadden, E.. “The European Bond Markets under EMU.” Oxford Review of Economic Policy, 20 (2004), 531–554.Google Scholar
Pástor, L., and Stambaugh, R. F.. “Liquidity Risk and Expected Stock Returns.” Journal of Political Economy, 111 (2003), 642–685.CrossRefGoogle Scholar
Strebulaev, I.“Liquidity and Asset Pricing: Evidence from the U.S. Treasury Securities Market.” Working Paper, Stanford University (2003).Google Scholar
Vayanos, D. “Flight to Quality, Flight to Liquidity, and the Pricing of Risk.” NBER Working Paper No. 10327 (2004).Google Scholar
Warga, A. “Bond Returns, Liquidity, and Missing Data.” Journal of Financial and Quantitative Analysis, 27 (1992), 605–617.Google Scholar