Abstract
This paper finds that both liquidity level and liquidity risk are important in explaining the cross-section of domestic government bond returns in 39 countries (both emerging and developed) around the world. After controlling for other market factors and bond characteristics, liquidity and liquidity risk together can explain as much as 0.41% per annum of extra yield for the highest versus the lowest liquidity risk countries (China and Argentina respectively). There is also evidence of a liquidity spillover from the U.S. equity market to domestic bond markets around the world. Employing a conditional model which allows both time-series and cross-sectional variation in liquidity betas, we find that the impact of liquidity risk is time varying across two different regimes: it increases in times of high uncertainty and is always larger in emerging than in developed countries. Nevertheless, the price of risk or premium required by investors for holding this time-varying risk is relatively stable.
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