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How Does Liquidity Affect Government Bond Yields?

Published online by Cambridge University Press:  26 November 2009

Carlo Favero
Affiliation:
Università Bocconi, IGIER, Università Commerciale Luigi Bocconi, Via Salasco 5, 20136 Milan, Italy. carlo.favero@uni-bocconi.it
Marco Pagano
Affiliation:
Department of Economics, Università di Napoli Federico II, Via Cintia, 80126 Naples, Italy. mrpagano@tin.it
Ernst-Ludwig von Thadden
Affiliation:
Department of Economics, Universität Mannheim, L 7,3-5, 68131 Mannheim, Germany. vthadden@pool.uni-mannheim.de

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
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

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