Abstract
The paper provides a high-frequency analysis of liquidity dynamics in the eurozone sovereign bond market over tranquil and crisis periods. We study time series of liquidity across the yield curve using high-frequency data from MTS, one of Europe’s leading electronic fixed-income trading platforms. We document flight-to-liquidity effects as investors prefer to trade on shorter-term benchmarks during liquidity dry-ups. We provide evidence of significant commonalities in spread and depth liquidity proxies which are weaker during the crisis period for both core and periphery economies although periphery countries display higher commonality than core countries during the crisis. We show that illiquidity of the periphery countries plays an important role in market dynamics and Granger causes illiquidity, volatility, returns, and CDS spreads across the maturity spectrum in both calm and crisis periods. Liquidity is priced both as a characteristic and as a risk factor even when controlling for credit risk, pointing to liquidity’s systematic dimension and importance.
Highlights
Market liquidity is important both as a characteristic and as a risk factor in international financial markets, especially during periods of increased market uncertainty
We investigate whether liquidity is priced across maturities using Impulse Response Functions from a multivariate vector autoregression (VAR) where we simultaneously model illiquidity, volatility, bond returns, and credit default swap (CDS) spreads across four maturities
The fourth and fifth sections examine Impulse Response Functions and the pricing of liquidity, and the sixth section refers to the pricing of systematic liquidity risk
Summary
Market liquidity is important both as a characteristic and as a risk factor in international financial markets, especially during periods of increased market uncertainty. In this study we undertake an in-depth analysis of liquidity commonality, liquidity dynamics, and liquidity pricing across the term structure of returns in the eurozone sovereign bond market using microstructure-based measures of liquidity. The European sovereign debt crisis offers a unique opportunity to study the behaviour of bond market liquidity over both crisis and tranquil periods and its interrelations with market volatility, returns, and sovereign credit risk. Liquidity deterioration during periods of stress can exacerbate investors’ perceptions about future liquidity, as required rates of return must increase to compensate for additional amounts of risk they undertake in the form of a risk premium (Amihud and Mendelson, 1986). It is often suggested that liquidity premia widen dramatically during extreme market episodes in tandem with flight-to-liquidity effects, suggesting that investors’ preferences shift toward possessing more liquid assets (Vayanos, 2004)
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