Payment Delays: Bias in the Yield Curve

Abstract:     
Most empirical research has found positive liquidity or term premiums. This paper shows that a completely spurious premium may be embedded in the observed yield curve. If payment delays - say, those due to check-clearing or brokerage accounts - in the government securities markets are priced, but are not explicitly incorporated into pricing equations, they cause divergences between the true time until maturity and the maturity reported in the financial press. This, in turn, causes yield curves constructed from observed rates to slope up, even if all forward rates are equal and if Hicks' pure-expectations theory (1946 - hereafter, PET) is true. These payment delays cause some estimators of premiums to have positive expected values, even if the PET is true. These apparent premiums are not only positive, but they also vary in a manner consistent with important empirical results. Therefore, the evidence concerning liquidity premiums must be re-examined.

Our results do not dispel all of the empirical evidence against the pure-expectations theory. They do, however, serve to caution researchers against dismissing the bias payment delays may induce.

Keywords: Liquidity premium, term structure, expectations, interest rates

JEL Classification: A1, E4, G1, G2

Accepted Paper Series