Euro Area Government Bond Market Liquidity

Abstract

We study the contribution of liquidity to time-series dynamics and cross-sectional variations of Euro area sovereign bond yield spreads. We consider a large sample period covering both the global financial crisis and the European sovereign crisis. Using intraday trade and quote data we construct several alternative liquidity measures and study their contribution to yield preads. When we control for standard risk factors, such as credit and term, liquidity does not provide a significant incremental explanatory contribution to the time-series dynamics of yields before the crisis period. Liquidity however becomes an important explanatory factor during the crisis period. In the cross-sectional analysis liquidity plays an important role in explaining yield spreads both before and during the crisis period. Amongst the various liquidity proxies the bid-ask spread consistently provides the largest incremental contribution to models for yield spreads.

Keywords: Market Microstructure, Asset Pricing, Liquidity, Sovereign Debt Crisis

JEL Classification: G01, G12, G15