The On-the-Run Liquidity Phenomenon

Posted: 4 Jun 2008

See all articles by Clara Vega

Clara Vega

Board of Governors of the Federal Reserve System

Paolo Pasquariello

University of Michigan, Stephen M. Ross School of Business

Abstract

We study the determinants of liquidity differentials between on-the-run and off-the-run U.S. Treasury bonds. To guide our analysis, we develop a parsimonious model of multi-asset speculative trading in which endowment shocks separate the on-the-run security from an otherwise identical off-the-run security. We then explore the equilibrium implications of these shocks on off/on-the-run liquidity differentials in the presence of two realistic market frictions - information heterogeneity and imperfect competition among informed traders - and a public signal. We test these implications by analyzing daily averages of intraday differences in bid-ask spreads for on-the-run and off-the-run three-month, six-month, and one-year U.S. Treasury bills and two-year, five-year, and ten-year U.S. Treasury notes. Our evidence suggests that i) off/on-the run liquidity differentials are economically and statistically significant, even after controlling for several of the bonds' intrinsic characteristics (such as duration, convexity, repo rates, or term premia), and ii) off/on-the-run liquidity differentials are smaller immediately following bond auction dates, and larger when the uncertainty surrounding the ensuing auction allocations is high, when the dispersion of beliefs across informed traders is high, and when macroeconomic announcements are noisy, consistent with our stylized model.

Keywords: Treasury Bond Markets, Strategic Trading, Market Microstructure, Liquidity, Order Flow, On-The-Run Bonds, Off-The-Run Bonds, Macroeconomic News Announcements, Expectations, Dispersion of Beliefs

JEL Classification: E44, G14

Suggested Citation

Vega, Clara and Pasquariello, Paolo, The On-the-Run Liquidity Phenomenon. Journal of Financial Economics (JFE), forthcoming, Ross School of Business Working Paper No. 1054, EFA 2007 Ljubljana Meetings Paper, Simon School Working Paper No. FR 06-09, Available at SSRN: https://ssrn.com/abstract=1139921

Clara Vega

Board of Governors of the Federal Reserve System ( email )

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

HOME PAGE: http://www.federalreserve.gov/research/staff/vegaclarax.htm

Paolo Pasquariello (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

709 Tappan Street
Room R4434
Ann Arbor, MI 48109
United States
734-764-9286 (Phone)
240-526-7168 (Fax)

HOME PAGE: http://webuser.bus.umich.edu/ppasquar/