Market Liquidity Risk Premia in Eurozone Government Bonds' Yield Spreads

Abstract

This paper is about market liquidity risk premia in Eurozone sovereign bond spreads between 2008 and 2015. By calibrating an arbitrage-free reduced form model to the cash- and derivatives markets of each member state, we disentangle credit and market liquidity spread components in government bonds and investigate their dynamics across the Euro Area. Short-term (2Y), medium-term (5Y) and long-term (10Y) government debt is in scope of the analysis.Furthermore, the relationship between government bonds and credit default swaps (basis) is examined by cointegration analysis, where we find evidence that short-term deviations from long-term equilibria are due to temporary illiquidity premia inherent in government bond spreads. Moreover, we show that the bond markets are more important for price determination than the credit default swap markets although significant spillover from the derivatives to the cash markets is present. Finally, the paper applies regression analysis to the liquidity driven bond/CDS basis to examine the proportion of systematic and idiosyncratic determinants of market liquidity premia. We conclude that these premia are largely determined by market-wide liquidity proxies such as the pfandbrief/bund spread and the banks' funding spread whereas unconventional monetary policy and idiosyncratic factors play a minor role.