If we have a look at the spread of a 29Y versus 30Y US Treasury Bond, we see it
rising from 5 bp to 25 bp in 2 Mths (Oct.–Dec. 98). Credit and option characteristics
of both bonds are the same (those spreads are zero for our bond trader).
The difference between the interest components can be neglected or at least do
not explain the large difference. A possible answer is that the ‘relative liquidity
relation’ (the one we meant intuitively to capture with this approach) between
both bonds can be assumed constant during this period. Nevertheless the
‘spot price’ of liquidity has changed dramatically during this period – quite
understandably, given the general situation in the markets with highlights as
emerging markets in Asia, LTCM, the MBS business of American investment
banks and others.
Another naive measure for liquidity is the concept of tradability of bonds. A
relatively small amount of bonds from an issue which are held for trading purposes
(assuming the rest are blocked in longer-term investment portfolios) will tend towards
higher liquidity premiums.
But does the liquidity premium depict the amount of ‘tradable’ bonds in the
market? It can be observed that bonds with a high liquidity margin are traded heavily
– in contrast to the theory. The explanation is that traders do not determine the
‘right’ price for a financial object; they try to ‘determine’ whether the spot price is
higher or lower than a future price; buy low – sell high. The same is true for liquidity
spreads. A high spread is not necessarily downsizing the amount of trades: if the
spread is anticipated to be stable or even to widen, it can even spur trading. All in
all we have to deal with the term structure of liquidity spreads. Unfortunately such a
curve does not exist, the main reason being that loan and deposit markets are
complementary markets from a bank’s point of view and, moreover, segregated into
different classes of credit risk.
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