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Bond Illiquidity and Excess Volatility

52 Pages Posted: 13 Mar 2008 Last revised: 19 May 2013

Jack Bao

Board of Governors of the Federal Reserve System

Jun Pan

Massachusetts Institute of Technology (MIT) - Economics, Finance, Accounting (EFA); National Bureau of Economic Research (NBER); China Academy of Financial Research (CAFR)

Date Written: May 9, 2013

Abstract

We find that the empirical volatilities of corporate bond and CDS returns are higher than implied by equity return volatilities and the Merton model. This excess volatility may arise because structural models inadequately capture either fundamentals or illiquidity. Our evidence supports the latter explanation. We find little relation between excess volatility and measures of firm fundamentals and the volatility of firm fundamentals, but some relation with variables proxying for time-varying illiquidity. Consistent with an illiquidity explanation, firm-level bond portfolio returns, which average out bond-specific effects, significantly decrease excess volatility.

Suggested Citation

Bao, Jack and Pan, Jun, Bond Illiquidity and Excess Volatility (May 9, 2013). AFA 2009 San Francisco Meetings Paper; Charles A. Dice Center Working Paper No. 2010-20; Fisher College of Business Working Paper No. 2010-03-020. Available at SSRN: https://ssrn.com/abstract=1104765 or http://dx.doi.org/10.2139/ssrn.1104765

Jack Bao

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Jun Pan (Contact Author)

Massachusetts Institute of Technology (MIT) - Economics, Finance, Accounting (EFA) ( email )

77 Massachusetts Avenue
Cambridge, MA 02139-4307
United States
617-253-3083 (Phone)
617-258-6855 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

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