The Term Structure of Liquidity Premium

48 Pages Posted: 7 Nov 2019 Last revised: 8 Mar 2020

See all articles by Wenhao Li

Wenhao Li

University of Southern California - Marshall School of Business

Yang Song

University of Washington - Michael G. Foster School of Business

Date Written: October 28, 2019

Abstract

We analyze the term structure of Treasury liquidity premium (LP). Through a model where illiquidity shocks can be alleviated by holding money and Treasuries, we show that the LP term structure is determined by (i) expectation of future liquidity conditions, (ii) liquidity term premium, (iii) monetary policy and the substitutability between money and Treasurys, and (iv) Treasury supply. Consistent with the model, we find that short-term LP is higher than long-term LP in recessions and is lower in booms. Moreover, forward LP strongly predicts future short-term LP and future market liquidity. We also find that policy interest rate significantly affects short-term LP, but not long-term LP, suggesting that money has high substitutability with short-term Treasurys but little substitutability with long-term Treasuries. We use the LP term structure to infer Treasury safety premium (SP). We find that SP contributes to Treasury convenience yields similarly to LP across maturities, and long-term SP is higher than short-term SP.

Suggested Citation

Li, Wenhao and Song, Yang, The Term Structure of Liquidity Premium (October 28, 2019). USC Marshall School of Business Research Paper. Available at SSRN: https://ssrn.com/abstract=3476730 or http://dx.doi.org/10.2139/ssrn.3476730

Wenhao Li (Contact Author)

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd
Los Angeles, CA 90089
United States

HOME PAGE: http://www.wenhao-li.com

Yang Song

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States

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