Working Paper: CEPR ID: DP6649
Authors: Carlo A. Favero; Marco Pagano; Ernst-Ludwig von Thadden
Abstract: The paper explores the determinants of yield differentials between sovereign bonds in the Euro area. There is a common trend in yield differentials, which is correlated with a measure of aggregate risk. In contrast, liquidity differentials display sizeable heterogeneity and no common factor. We propose a simple model with endogenous liquidity demand, where a bond's liquidity premium depends both on its transaction cost and on investment opportunities. The model predicts that yield differentials should increase in both liquidity and risk, with an interaction term of the opposite sign. Testing these predictions on daily data, we find that the aggregate risk factor is consistently priced, liquidity differentials are priced for a subset of countries, and their interaction with the risk factor is in line with the model's prediction and crucial to detect their effect.
Keywords: bond yields; euro area; liquidity; risk
JEL Codes: E43; J12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| aggregate risk (E10) | yield differentials (F16) |
| liquidity differentials (E41) | yield differentials (F16) |
| liquidity differentials + aggregate risk (E41) | yield differentials (F16) |