Bond Liquidity Premia
Bank of Canada
EDHEC Business School
June 30, 2009
Review of Financial Studies, (2012) 25 (4):1207-1254
EFA 2009 Bergen Meetings Paper
Asset pricing models of limits to arbitrage emphasize the role of funding conditions faced by financial intermediaries. In the US, the Treasury repo market is the key funding market and, hence, theory predicts that the liquidity premium of Treasury bonds share a funding liquidity component with risk premia in other markets. We identify and measure the value of funding liquidity from the cross-section of bonds by adding a liquidity factor correlated with age to an arbitrage-free term structure model. We validate our interpretation of this funding liquidity factor by establishing its linkages with other measures of funding conditions at three different levels of aggregation. Looking at asset pricing implications, we find that an increase in the value of liquidity predicts lower risk premia for on-the-run and off-the-run bonds but higher risk premia on LIBOR loans, swap contracts and corporate bonds. The impact is large and pervasive through crisis and normal times. Conditions on funding markets have a first-order impact on interest rates.
Number of Pages in PDF File: 60
Keywords: Bond Prices, Term Structure, Funding Liquidity
JEL Classification: E43, H12
Date posted: March 1, 2007 ; Last revised: November 22, 2012
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