Abstract
We examine the effects of liquidity and information risks on expected returns of U.S. government bonds. Information risk is measured by probability of information-based trading (PIN) derived from the market microstructure model of Easley, Hvidkjaer, and O'Hara (2002). Liquidity risk is captured by sensitivity of individual bond returns to a market-wide liquidity measure along the line of Pastor and Stambaugh (2003). Controlling for systematic risks and bond characteristics, we find that both liquidity and information risks have a significantly positive effect on expected bond returns. Our findings suggest that incorporating microstructure factors into existing term structure models is a promising avenue for improving our understanding of bond price behavior.
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