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How Does Liquidity Affect Government Bond Yields?

Carlo Favero (), Marco Pagano () and Ernst-Ludwig von Thadden

No 323, Working Papers from IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University

Abstract: 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.

Date: 2007
New Economics Papers: this item is included in nep-eec and nep-mac
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Journal Article: How Does Liquidity Affect Government Bond Yields? (2010) Downloads
Working Paper: How Does Liquidity Affect Government Bond Yields? (2008) Downloads
Working Paper: How Does Liquidity Affect Government Bond Yields? (2007) Downloads
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