Working Paper: CEPR ID: DP3900
Authors: David Goldreich; Bernd Hanke; Purnendu Nath
Abstract: This Paper examines the price differences between very liquid on-the-run US Treasury securities and less liquid off-the-run securities over the entire on/off cycle. Unlike previous studies, by comparing pairs of securities as their relative liquidity varies over time, we can disregard any cross-sectional differences between the securities. Also, since the liquidity of Treasury notes varies predictably over time we are able to distinguish between current liquidity and expected future liquidity. We show that the more liquid security is priced higher on average, but that this difference depends on the amount of expected future liquidity over its remaining lifetime rather than its current liquidity. We measure future liquidity using both quotes and trades. The liquidity measures include bid-ask spread, depth and trading activity. Examining a variety of liquidity measures enables us to evaluate their relative importance and to identify the liquidity proxies that most affect prices. Although all the measures are highly correlated with one another, we find that quoted bid-ask spread and quoted depth are more important than effective spread and trade size, respectively. Among measures of market activity, however, the number of trades and volume are more related to the liquidity premium than the number of quotes.
Keywords: Asset Pricing; Liquidity
JEL Codes: G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| current liquidity (E41) | yield difference between on-the-run and off-the-run securities (E43) |
| expected future liquidity (G33) | yield difference between on-the-run and off-the-run securities (E43) |
| expected future liquidity (G33) | liquidity premium (E41) |
| liquidity premium (E41) | yield difference between on-the-run and off-the-run securities (E43) |
| expected future trading costs (G13) | liquidity premium (E41) |
| bid-ask spreads and trading activity (G19) | liquidity premium (E41) |