The 'Ostrich Effect' and the Relationship between the Liquidity and the Yields of Financial Assets

Abstract

This paper documents a puzzling observed anomaly in the relative value of a liquid and comparable illiquid asset. During a prolonged period of time Government T-bills provided a higher Yield to Maturity than an equally risky illiquid asset (bank deposits). This cannot be attributed to taxes, risk or transaction costs. We relate our finding to the literature on behavioral finance and, more specifically,to the Myopic Loss Aversion literature (MLA) that investigates the impact of the frequency of investment information flow on investment decisions. We suggest that the observed puzzle is due to the positive correlation between liquidity and the flow of market information. We use the term Ostrich Effect, to describe investor behavior, since ostriches are believed to treat apparently risky situations by pretending they do not exist. As predicted by the Ostrich Effect, we find that the difference between the return on the liquid asset relative to the illiquid asset is higher in periods of greater uncertainty.

Keywords: Liquidity, Behavioral Finance, Mental Accounting

JEL Classification: G14