Stock Market Illiquidity, Funding Liquidity, and Bond Risk Premia
Kees E. Bouwman
Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)
RSM Erasmus University; Duisenberg School of Finance
Wing Wah Tham
Erasmus School of Economics - Econometric Institute
November 11, 2011
Asian Finance Association (AsFA) 2013 Conference
26th Australasian Finance and Banking Conference 2013
In this paper, we study the link between government bonds and cross-section of stocks. We provide new evidence that links the stock market liquidity to sovereign bond risk premia. We find that the stock market illiquidity variable adds to the well-established Cochrane-Piazzesi and Ludvigson-Ng factors. It explains 10%, 9%, 7%, and 7% of the one-year-ahead variation in the excess return for two-, three-, four-, and five-year bonds respectively and increases the adjusted R2 by 3-6% across all maturities over Cochrane and Piazzesi (2005) and Ludvigson and Ng (2009) factors. The effects are highly statistically and economically significant both in and out of sample. We find that our result is robust to and is not driven by information from open interest in the futures market, long-run inflation expectations, and dispersion in beliefs. We argue that stock market illiquidity is a timely variable that is associated with the state of funding liquidity.
Number of Pages in PDF File: 57
Keywords: Market liquidity, Bond risk premia, Flight-to-quality
JEL Classification: G10, G20, G14
Date posted: March 20, 2012 ; Last revised: December 5, 2013
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