Citation

Discussion Paper Details

Please find the details for DP6649 in an easy to copy and paste format below:

Full Details   |   Bibliographic Reference

Full Details

Title: How Does Liquidity Affect Government Bond Yields?

Author(s): Carlo A. Favero, Marco Pagano and Ernst-Ludwig von Thadden

Publication Date: January 2008

Keyword(s): Bond yields, euro area, liquidity and risk

Programme Area(s): Financial Economics

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.

For full details and related downloads, please visit: https://cepr.org/active/publications/discussion_papers/dp.php?dpno=6649

Bibliographic Reference

Favero, C, Pagano, M and von Thadden, E. 2008. 'How Does Liquidity Affect Government Bond Yields?'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=6649