Measuring the liquidity impact on EMU government bond prices

Abstract

The work reported in this paper aimed to measure the impact of liquidity on European Monetary Union (EMU) government bond prices. Although there is a growing theoretical and empirical literature on liquidity effects in fixed income markets there is no clear answer to the questions how to measure liquidity and whether liquidity is priced in the market at all. The empirical analysis here is based on a unique data set containing individual bond data from six major EMU government bond markets, allowing one to compare yield curves estimated for subportfolios formed with respect to different potential liquidity measures. In a second procedure, liquidity measures are collected on the individual bond level and estimated pricing errors, given some reference yield curve, are regressed against these liquidity variables. This enables the conduction of formal tests on the pricing impact of liquidity measures. Results indicate that the benchmark property and the number of contributors are the most promising liquidity proxies having significant results in most countries. The results do not support the hypothesis that other liquidity measures under consideration, such as the on-the-run property, the issue size, and bid–ask spread related measures have a persistent price impact. A cross-country analysis of the subportfolio level indicates that liquidity effects cannot explain the size of the yield spreads between different issuers. This implies that effects other than liquidity, such as credit risk, are important driving factors of cross-country yield spreads.