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Liquidity and its Impact on Bond Prices

Schmalenbach Business Review, Vol. 52, January 2000

19 Pages Posted: 3 Jun 2002  

Marliese Uhrig-Homburg

Karlsruhe Institute of Technology (KIT) - Institute for Finance

Alexander Kempf

University of Cologne - Department of Finance & Centre for Financial Research (CFR)

Abstract

In this paper, we propose a theoretical continuous-time model to analyze the impact of liquidity on bond prices. This model prices illiquid bonds relative to liquid bonds and provides a testable theory of illiquidity induced price discounts. The model is tested using 1992-1994 data from bonds issued by the German government. These bonds define a market segment that is homogeneous in bankruptcy risk, taxes, age, and coupons, but the bonds differ with respect to their liquidity. The empirical findings suggest that bond prices not only depend on the dynamics of interest rates, but also on the liquidity of bonds. Therefore, bond liquidity should be used as an additional pricing factor. The findings of the out-of-sample test demonstrate the superiority of the model in comparison with traditional pricing models.

Suggested Citation

Uhrig-Homburg, Marliese and Kempf, Alexander, Liquidity and its Impact on Bond Prices. Schmalenbach Business Review, Vol. 52, January 2000. Available at SSRN: https://ssrn.com/abstract=311025 or http://dx.doi.org/10.2139/ssrn.311025

Marliese Uhrig-Homburg

Karlsruhe Institute of Technology (KIT) - Institute for Finance ( email )

P.O. Box 6980
D-76049 Karlsruhe, DE
Germany
+49 721 6084 8183 (Phone)
+49 721 6084 8190 (Fax)

HOME PAGE: http://derivate.fbv.kit.edu/english/index.php

Alexander Kempf (Contact Author)

University of Cologne - Department of Finance & Centre for Financial Research (CFR) ( email )

Cologne, 50923
Germany
+49 221 470 2714 (Phone)
+49 221 470 3992 (Fax)

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