Valutation, Liquidity and Risk in Government Bond Markets

We explore 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 the international risk factor. In contrast, liquidity differentials display sizeable heterogeneity
and no common factor. We present a model that predicts that yield differentials
should increase in both liquidity and risk, with an interaction term whose magnitude and
sign depends on the size of the liquidity differential with respect to the reference country.
Testing these predictions on daily data, we find that the international risk factor is consistently
priced, while liquidity differentials are priced only for a subset of countries and
their interaction with the risk factor is crucial to detect their effect.