A Measure of Liquidity Risk in a Sovereign Debt Market
20 Pages Posted: 16 Sep 2011
Date Written: September 16, 2011
Abstract
Since the seminal paper of Vasicek and Fong (1982) term structure models are estimated assuming that yields are cross-sectionally homokedastic. In this paper, we show that this hypothesis does not hold even for bonds from the same issuer when there are differences in their level of liquidity. Those bonds with a lower daily turnover would experiment a higher volatility around the expected yield determined by the term structure. The existence of a minimum tick size on the bond price negotiation would also produce a higher volatility for those bonds approaching their expiration term. In order to show these effects, we use data from Spanish sovereign bonds from 1988 to 2010, covering more than 700 bonds and 5000 days. With these data we have estimated the out-of-sample error for each bond and day. The variance of these errors is negatively correlated with the turnover of each bond and its duration, while the mean of the error is directly correlated with the estimated variance. Taking into account these features we propose, for fitting the term structure, a modified Svensson (1994) yield curve model where an additional liquidity term is added and parameters are estimated by weighted least squared errors to take into account the liquidity-induced heterokedasticity.
Keywords: liquidity risk, liquidity premium, yield curve, Spanish Sovereign Bonds
JEL Classification: G12, C58, E43
Suggested Citation: Suggested Citation
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