How Does Liquidity Affect Government Bond Yields?

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. JEL classification numbers: E43, G12.

Systemic and Idiosyncratic Risk in EU‐15 Sovereign Yield Spreads after Seven Years of Monetary Union

“…Nevertheless, it is important to note that Geyer et al's measurement of liquidity variables is more indirect than ours, as they do not use data on bid-ask spreads; furthermore, and on the other hand, Pagano and von Thadden work with data taken from the euro MTS trading platform which includes only the transactions made through this platform and not in the whole market, which is the source we use in our paper. However, Favero et al (2009) recognise that aggregate (global) risk and liquidity may interact with each other in non-trivial manners, and so their results are more consistent with the ones presented in this paper. Specifically, these authors propose a simple asset-pricing model with exogenous transactions and endogenous liquidity demand, where a bond's liquidity premium depends both on its transaction cost and on investment opportunities.…”

“…Z L i,t represents the interaction between them, and ε i,t is an error term. Following Favero et al (2009) 3 we allow yields to be explained in terms of exogenous risk premiums (specifically, banking risk premiums in the USA) which will appear in the regression both linearly and interacting with the domestic risk variables. The interaction term needs to be included to avoid the omitted variables problem.…”

Family Firms, Corporate Governance and Export

“…Some papers show that in the USA, family firms tend to have higher profitability than non-family firms (Anderson and Reeb 2003;Villalonga and Amit 2006). Recent studies on European countries find that family-owned firms perform better than widely held ones (Sraer and Thesmar 2007;Favero et al 2010;Maury 2006). These findings are often interpreted as supporting the theoretical hypothesis that family ownership reduces classic agency problems between owners and managers, such as managers' short-termism (Fama and Jensen 1983).…”

Benchmark Bonds Interactions under Regime Shifts

“…Similar investigations can be found in other studies investigating for example the interactions between international and small stock markets as subject to regime switches by using the smooth transition regression model or in studies that formulate a Markov switching framework for the examination of spillover effects among major equity market indices and the corresponding futures contracts written on them (Bredin and Hyde, 2008;Sarno and Valente, 2005). 2 The EMU markets of the set (namely Germany, France, Italy and the Netherlands) were chosen under the criterion of significance, as they either reflect benchmark characteristics (Germany and France for the whole system of EMU bond markets and Italy for the highyielders' sector according to Lane (2006)) or concentrate increased liquidity and foreign portfolio participation (such as the Netherlands, according to Lane (2006) and Favero et al (2008)). Empirically, the present paper has various implications, providing answers to questions concerning international bond markets interactions.…”