Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads

54 Pages Posted: 10 Oct 2009 Last revised: 11 Sep 2020

See all articles by Krista Schwarz

Krista Schwarz

Board of Governors of the Federal Reserve System

Date Written: September 25, 2018

Abstract

Euro-area sovereign bond and interbank interest rate spreads widened sharply in the 2007-2009 Global Financial Crisis and over the subsequent European Debt Crisis, greatly increasing financing costs. Such rate volatility could represent concerns over asset liquidity or issuer solvency. To precisely identify the relative contribution of these two effects in interest rate spreads, this paper uses a model-free measure of euro-area bond market liquidity. Liquidity accounts for 36% of the trough-to-peak sovereign spread widening during the Financial Crisis and 21% in the Debt Crisis, after controlling for default risk. Aggregate bond liquidity also explains a substantial portion of interbank spreads.

Keywords: market liquidity, interbank credit, liquidity risk, money markets, interest rates, financial crisis

JEL Classification: E44, G01, G12, G15

Suggested Citation

Schwarz, Krista, Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads (September 25, 2018). Jacobs Levy Equity Management Center for Quantitative Financial Research Paper , Available at SSRN: https://ssrn.com/abstract=1486240 or http://dx.doi.org/10.2139/ssrn.1486240

Krista Schwarz (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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

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