Term structure estimation, liquidity-induced heteroskedasticity and the price of liquidity risk

Emma Berenguer (), Ricardo Gimeno and Juan M. Nave
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Juan M. Nave: Universidad de Castilla-La Mancha

No 1308, Working Papers from Banco de España

Abstract: Since the seminal paper of Vasicek and Fong (1982), the term structures of interest rates have been fitted assuming that yields are cross-sectionally homoskedastic. We show that this assumption does not hold when there are differences in liquidity, even for bonds of the same issuer. Lower turnover implies higher volatility. In addition, a minimum tick size for bond price negotiation will produce higher volatility for bonds approaching their maturity dates. To show these effects, we use data for Spanish sovereign bonds from 1988 to 2010, covering more than 700 bonds and 5000 trading days. We estimate the out-ofsample error for each bond and day. The variance of these errors is found to be negatively correlated with each bond’s turnover and duration, while the mean of the errors is found to be directly correlated with the estimated variance. As a result, we propose a modified Svensson (1994) yield curve model to fit the term structure, adding a liquidity term and estimating parameters by weighted least-squared errors to take into account the liquidityinduced heteroskedasticity.

Keywords: heteroskedasticity; liquidity premium; yield curve fitting; Spanish sovereign bonds (search for similar items in EconPapers)
JEL-codes: C58 E43 G12 (search for similar items in EconPapers)
Pages: 27 pages
Date: 2013-05
New Economics Papers: this item is included in nep-mac and nep-ore
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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