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Stock Market Illiquidity, Funding Liquidity, and Bond Risk Premia

57 Pages Posted: 20 Mar 2012 Last revised: 5 Dec 2013

Kees E. Bouwman

Cardano Risk Management

Elvira Sojli

UNSW Business School, School of Banking and Finance; RSM Erasmus University

Wing Wah Tham

University of New South Wales (UNSW)

Date Written: November 11, 2011

Abstract

In this paper, we study the link between government bonds and cross-section of stocks. We provide new evidence that links the stock market liquidity to sovereign bond risk premia. We find that the stock market illiquidity variable adds to the well-established Cochrane-Piazzesi and Ludvigson-Ng factors. It explains 10%, 9%, 7%, and 7% of the one-year-ahead variation in the excess return for two-, three-, four-, and five-year bonds respectively and increases the adjusted R2 by 3-6% across all maturities over Cochrane and Piazzesi (2005) and Ludvigson and Ng (2009) factors. The effects are highly statistically and economically significant both in and out of sample. We find that our result is robust to and is not driven by information from open interest in the futures market, long-run inflation expectations, and dispersion in beliefs. We argue that stock market illiquidity is a timely variable that is associated with the state of funding liquidity.

Keywords: Market liquidity, Bond risk premia, Flight-to-quality

JEL Classification: G10, G20, G14

Suggested Citation

Bouwman, Kees E. and Sojli, Elvira and Tham, Wing Wah, Stock Market Illiquidity, Funding Liquidity, and Bond Risk Premia (November 11, 2011). Asian Finance Association (AsFA) 2013 Conference; 26th Australasian Finance and Banking Conference 2013. Available at SSRN: https://ssrn.com/abstract=2019094 or http://dx.doi.org/10.2139/ssrn.2019094

Kees E. Bouwman

Cardano Risk Management ( email )

Rotterdam 3011 AA
Netherlands

Elvira Sojli (Contact Author)

UNSW Business School, School of Banking and Finance ( email )

Sydney, NSW 2052
Australia

HOME PAGE: http://sites.google.com/site/esojli/

RSM Erasmus University ( email )

Finance Department T8-44
Burgemeester Oudlaan 50, PO Box 1738
Rotterdam, 3000DR
Netherlands
0031104082824 (Phone)

HOME PAGE: http://www.rsm.nl/people/elvira-sojli/

Wing Wah Tham

University of New South Wales (UNSW)

Sydney, NSW 2052
Australia

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