Bond pricing with a surface of zero coupon yields

We present a new method for consistent cross‐sectional pricing of all traded bonds in the fixed income market. By applying thin plate regression splines ( Wood, 2003 ) to bootstrapped zero coupon bond yields ( Hagan and West, 2006 ), the method decomposes traded yields into a risk‐free component plus premia for credit and liquidity risks, where the decomposition is consistent with the market valuations and underlying cash flows of the bonds. We apply the framework to end of quarter yield data from 2008 to 2011 on Australian dollar denominated semi‐government, supranational and agency (SSA) bonds, and find that the surface provides an excellent fit to the underlying zero coupon yield curves. Further, the decomposition of selected yield time series and cross‐sections demonstrates how credit premia increased for Australian SSA bonds through the Global Financial Crisis (GFC), but were counterbalanced by liquidity discounts as investors sought safe haven securities.     

Liquidity and credit premia in the yields of highly-rated sovereign bonds

This paper quantifies liquidity and credit premia in German and French government bond yields. For this purpose, we estimate term structures of government-guaranteed agency bonds and exploit the fact that differences in their yields vis-à-vis government bonds are mainly driven by liquidity effects. Adding information on benchmark rates, we estimate liquidity and credit premia as latent factors in a state-space framework. The results allow us, first, to quantify the price impact of safe-haven flows on sovereign yields, which strongly affected very liquid bond markets during the recent financial crisis. Second, we quantify credit premia for highly rated governments, offering an important alternative to the information based on CDS markets.     

Credit risk in covered bonds

Covered bonds are a promising alternative for prime mortgage securitization. In this paper, we explore risk premia in the covered bond market and particularly investigate whether and how credit risk is priced. In extant literature, yield spreads between high-quality covered bonds and government bonds are often interpreted as pure liquidity premia. In contrast, we show that although liquidity is important, it is not the exclusive risk factor. Using a hand-collected data set of cover pool information, we find that the credit quality of the cover assets is an important determinant of covered bond yield spreads. This effect is particularly strong in times of financial turmoil and has a significant influence on the issuer's refinancing cost.     

Stochastic cash flow constraints and the term structure of interest

This paper attempts to provide a theoretical foundation for liquidity premia to be found in the term structure of interest rates. These premia arise from the borrowers' future availability of cash and from the lenders' future need for cash. In addition a third category of investors are active on the market: speculators who have no cash constraint and take positions on the basis of their expectations of future spot rates only. The interaction between these three groups yields an equilibrium term structure which is tested empirically; the test produces estimates of the relative weights of the groups in the determination of liquidity premia. Analysis of these weights indicates that there exists some market segmentation between bonds of different maturities.     

Liquidity and Pricing of Credit Default Swaps in Japan: Evidence from a Benchmark Index for Corporate Debt Claims

This article is a contribution towards the growing empirical literature on the relationship between liquidity and pricing of credit default swaps (CDSs). To the best of my knowledge, the article becomes the first to show that market liquidity does matter to CDS pricing in Japan, by looking into a sole benchmark index of CDS trading for investment-grade debt claims, or the Markit iTraxx Japan (MiJ). The impact of illiquidity on MiJ premia has declined since the International Swaps and Derivatives Association introduced new trade practices in April 2009. The liquidity of the MiJ has increased since the Japan Securities Clearing Corporation started operating as a central counterpart for the MiJ in July 2011. The price discovery ability of the MiJ has also increased since then.     

Comparing possible proxies of corporate bond liquidity

We consider nine different proxies (issued amount, listed, euro, on-the-run, age, missing prices, yield volatility, number of contributors and yield dispersion) to measure corporate bond liquidity and use a four-variable model to control for interest rate risk, credit risk, maturity and rating differences between bonds. The null hypothesis that liquidity risk is not priced in our data set of euro corporate bonds is rejected for eight out of nine liquidity proxies. We find significant liquidity premia, ranging from 13 to 23 basis points. A comparison test between liquidity proxies shows limited differences between the proxies.     

Investor strategies in the green bond market: The influence of liquidity risks,economic factors and clientele effects

The green bond market has dramatically expanded especially in Europe but severe liquidity issues may undermine its rapid development. If few studies have assessed the implied liquidity risks for investors in terms of liquidity premium, none of them have specifically analysed its behavior across bond maturities. To fill this gap, this paper studies the term structure of the liquidity premium of the green bond market.We find that the sizes of short-term and long-term premia are close to those estimated on the German government bond market. We show that those premia are affected by economic factors and by spillover effects between them, which contribute to the U-Shape of the liquidity premium. Finally, we detect a liquidity clientele effect on the ask side impacting the liquidity premium, which implies a maturity segmentation i.e., high-risk (resp. low-risk) investors buy short-term (resp. long-term) green bonds and hold them until maturity.Taken together, our results deliver valuable insights on investors' strategies in the green bond market. Quite importantly, green bond investors prefer to opt for buy and hold strategies because they are compensated for higher liquidity risks along the entire maturity spectrum.     

Multimarket trading and corporate bond liquidity

Global bonds are international securities traded and settled efficiently in multiple markets. This paper examines global bonds to evaluate the effects of multimarket trading on corporate bond liquidity and pricing. The results show that global bonds are significantly more liquid than similar-sized domestic bonds of the same issuers, and their liquidity advantage is reflected in higher market valuations. These findings support microstructure models that predict a positive relation between the number of potential investors and liquidity in over-the-counter markets, and help explain the increasing use of global bonds by corporate issuers.     

Covered interest arbitrage profits: The role of liquidity and credit risk

We study the profitability of Covered Interest Parity (CIP) arbitrage violations and their relationship with market liquidity and credit risk using a novel and unique dataset of tick-by-tick firm quotes for all financial instruments involved in the arbitrage strategy. The empirical analysis shows that positive CIP arbitrage deviations include a compensation for liquidity and credit risk. Once these risk premia are taken into account, small arbitrage profits only accrue to traders who are able to negotiate low trading costs. The results are robust to stale pricing and the nonsynchronous trading occurring in the markets involved in the arbitrage strategy.     

Liquidity risk and expected corporate bond returns

This paper studies the pricing of liquidity risk in the cross section of corporate bonds for the period from January 1994 to March 2009. The average return on bonds with high sensitivities to aggregate liquidity exceeds that for bonds with low sensitivities by about 4% annually. The positive relation between expected corporate bond returns and liquidity beta is robust to the effects of default and term betas, liquidity level, and other bond characteristics, as well as to different model specifications, test methodologies, and a variety of liquidity measures. The results suggest that liquidity risk is an important determinant of expected corporate bond returns.     

Expected Returns,Time-varying Risk,and Risk Premia

A new empirical model for intertemporal capital asset pricing is presented that allows both time-varying risk premia and betas where the latter are identified from the dynamics of the conditional covariance of returns. The model is more successful in explaining the predictable variations in excess returns when the returns on the stock market and corporate bonds are included as risk factors than when the stock market is the single factor. Although changes in the covariance of returns induce variations in the betas, most of the predictable movements in returns are attributed to changes in the risk premia.     

Risk premia,asset price bubbles,and monetary policy

We develop a dynamic general equilibrium asset pricing model with heterogeneous beliefs to study the effects of monetary policy on prices, risk premia, asset price bubbles, and financial stability. We propose a new framework for monetary policy with respect to bubbles. Because bubble risk premia arise from an interaction between disagreements among investors and dynamic trading constraints, under a non-accommodative monetary policy, liquidity adjusted risk and bubble risk premia increase. What matters for policy is the trading constrained fraction/mass of agents that disagree about fundamentals (i.e. optimists/pessimists). Accommodative policy can lead to a larger fraction of trading constrained agents that disagree, larger bubbles, and increased systemic risk. An implication of our results is that accommodative monetary policy in response to the Covid-19 crisis does not increase systemic risk due to asset price bubbles, as long as the policy keeps inflation under control.     

Liquidity,default, taxes,and yields on municipal bonds

We examine the effects of liquidity, default and personal taxes on the relative yields of Treasuries and municipals using a generalized model with liquidity risk. The municipal yield model includes liquidity as a state factor. Using a unique transaction dataset, we estimate the liquidity risk of municipals and its effect on bond yields. Empirical evidence shows that municipal bond yields are strongly affected by all three factors. The effects of default and liquidity risk on municipal yields increase with maturity and credit risk. Liquidity premium accounts for about 9–13% of municipal yields for AAA bonds, 9–15% for AA/A bonds and 8–19% for BBB bonds. A substantial portion of the maturity spread between long- and short-maturity municipal bonds is attributed to the liquidity premium. Ignoring the liquidity risk effect thus results in a severe underestimation of municipal bond yields. Conditional on the effects of default and liquidity risk, we obtain implicit tax rates very close to the statutory tax rates of high-income individuals and institutional investors. Furthermore, these implicit income tax rates are quite stable across bonds of different maturities. Results show that including liquidity risk in the municipal bond pricing model helps explain the muni puzzle.     

Liquidity,Maturity, and the Yields on U.S. Treasury Securities

The effects of asset liquidity on expected returns for assets with infinite maturities (stocks) are examined for bonds (Treasury notes and bills with matched maturities of less than 6 months). The yield to maturity is higher on notes, which have lower liquidity. The yield differential between notes and bills is a decreasing and convex function of the time to maturity. The results provide a robust confirmation of the liquidity effect in asset pricing.     

Measuring systemic risk-adjusted liquidity (SRL)—A model approach

Little progress has been made so far in addressing—in a comprehensive way—the negative externalities caused by excessive maturity transformation and the implications for effective liquidity regulation of banks. The SRL model combines option pricing theory with market information and balance sheet data to generate probabilistic measure of systemic liquidity risk. It enhances price-based liquidity regulation by linking a bank’s maturity mismatch impacting the stability of its funding with those characteristics of other banks, subject to individual changes in risk profiles and common changes in market conditions impacting funding and market liquidity risk. This approach can then be used (i) to quantify an individual institution’s time-varying contribution to expected losses from system-wide liquidity shortfalls and (ii) to price insurance premia that provide incentives for banks to internalize the social cost of their individual funding decisions.     

A Model of Monetary Policy and Risk Premia

We develop a dynamic asset pricing model in which monetary policy affects the risk premium component of the cost of capital. Risk‐tolerant agents (banks) borrow from risk‐averse agents (i.e., take deposits) to fund levered investments. Leverage exposes banks to funding risk, which they insure by holding liquidity buffers. By changing the nominal rate the central bank influences the liquidity premium, and hence the cost of taking leverage. Lower nominal rates make liquidity cheaper and raise leverage, resulting in lower risk premia and higher asset prices, volatility, investment, and growth. We analyze forward guidance, a “Greenspan put,” and the yield curve.     

Trading strategies based on term structure model residuals

The term structure of interest rates is an important input for basically every pricing model and is mostly calibrated on coupon bond prices. Therefore, the estimated interest rates should accurately explain the market prices of these bonds. However, nearly all empirical papers on interest rate estimation, e.g. Svensson, L.E.O. 1994. Estimating and interpreting forward interest rates: Sweden 1992–1994, IMF Working Paper, International Monetary Fund, report significant pricing errors in their sample. So an important question is what drives these pricing errors of the bonds. One simple explanation would be different tax treatment or different liquidity, but most papers on this research topic, e.g. Elton, E., and T.C. Green. 1998. Tax and liquidity effects in pricing government bonds. Journal of Finance 53: 1533–62, cannot fully explain the observed pricing errors. Therefore, these errors must be at least partially caused by either model misspecification or by the deviation of particular bond prices from general market conditions, i.e. mispricing revealing insufficient market efficiency. We provide empirical evidence for the German government bond market that risk-adjusted trading strategies based on bond pricing errors can yield about 15 basis points p.a. abnormal return compared to benchmark portfolios. Furthermore, the abnormal returns are continuously achieved over the whole time period and not randomly on a few days and show a relation to changes in the level and the curvature of the term structure of interest rates. Therefore, pricing errors contain economic information about deviations of bond prices from general market conditions and are not exclusively caused by model misspecification and/or differences in liquidity and tax treatment of individual bonds.     

Quantitative Asset Pricing Implications of Endogenous Solvency Constraints

We study the asset pricing implications of an economy wheresolvency constraints are endogenously determined to deter agentsfrom defaulting while allowing as much risk sharing as possible.We solve analytically for efficient allocations and for thecorresponding asset prices, portfolio holdings, and solvencyconstraints for a simple example. Then we calibrate a more generalmodel to U.S. aggregate as well as idiosyncratic income processes.We find equity premia, risk premia for long-term bonds, andSharpe ratios of magnitudes similar to the U.S. data for lowriskaversion and a lowtime-discount factor.     

Explaining the Magnitude of Liquidity Premia: The Roles of Return Predictability,Wealth Shocks,and State‐Dependent Transaction Costs

Constantinides (1986) documents how the impact of transaction costs on per‐annum liquidity premia in the standard dynamic allocation problem with i.i.d. returns is an order of magnitude smaller than the cost rate itself. Recent papers form portfolios sorted on liquidity measures and find spreads in expected per‐annum return that are the same order of magnitude as the transaction cost spread. When we allow returns to be predictable and introduce wealth shocks calibrated to labor income, transaction costs are able to produce per‐annum liquidity premia that are the same order of magnitude as the transaction cost spread.     

Tax and Liquidity Effects in Pricing Government Bonds

Daily data from interdealer government bond brokers are examined for tax and liquidity effects. We use two approaches to create cash flow matching portfolios of similar securities and look for pricing discrepancies associated with liquidity or tax effects. We also look for the presence of tax and liquidity effects by including a liquidity term when fitting a cubic spline to the after-tax yield curve. We find evidence of tax timing options and liquidity effects. However, the effects are much smaller than previously reported and the effects of liquidity are primarily due to high volume bonds with long maturities.