hero working papers

How Does Liquidity Affect Government Bond Yields?

Number: 323
Year: 2007
Author(s): Carlo Favero, Marco Pagano and Ernst-Ludwig von Thadden
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.