Many Faces of Liquidity and Asset Pricing: Evidence from the U.S. Treasury Securities Market

Abstract:     
This paper tests the illiquidity premium hypothesis using U.S. Treasury securities intraday interdealer data. In contrast to the existing literature where notes are matched with bills in terms of maturity date, we compare notes with other notes maturing on the same day. One reason for comparing notes with notes rather than notes with bills is that differences in tax treatment across bills and notes could confront an experiment to measure the illiquidity effect. We find that notes are quoted at essentially identical prices despite substantial differences in their liquidity. This rejection of the hypothesis is in sharp contrast to the result of previous studies (Amihud and Mendelson, 1991). Therefore we reconsider the evidence based on matched bills and notes. We identify cross-sectional variation in bill-note pricing differences that cannot be supported by the illiquidity premium hypothesis. We also show that the pricing difference is smaller for matches with on-the-run bills, although the difference in liquidity between these bills and notes is significantly larger.

Keywords: pricing, liquidity, market imperfections, bond markets, tax arbitrage

JEL Classifications: G10, G12

Working Paper Series