Abstract
We model the term structure of interest rates on Treasury bills as attributable to transaction cost, in particular to the bid-ask spread on T-bills. Since the bid-ask spread on a bill is increasing in maturity, part of the term premium can be modeled as a premium for differential liquidity, the transaction cost difference between bills of different maturity. Empirical results show that the bid-ask spread on Treasury bills is priced in the bill market and accounts for a substantial portion of the term premium, sometimes to the exclusion of a risk premium in the term structure.
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