Liquidity and international bond pricing

This thesis focuses on the liquidity risk and its impact on bond prices of the international markets and comprises three self-contained research papers. In the first research paper, we examine the role of the liquidity in the pricing of sovereign U.S. dollar bonds in emerging markets. We extend Acharya and Pedersen’s (2005) liquidity-adjusted capital asset pricing model to the bond market and find that both liquidity level and multiple liquidity risks are priced factors for the expected excess return of U.S. dollar bonds issued by developing countries. The combined effects of liquidity risk and liquidity level can explain as much as 1% per annum extra yield spread for the countries that have higher liquidity betas. Countries, which have a high correlation with the global market or U.S. stock market, have higher required bond returns than low correlation countries. The liquidity factor helps explain the credit spread puzzle of high yields. Our empirical results also support a flight to liquidity across the studied countries and are robust after controlling for bond characteristics and the U.S. risk factors. The second research 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 level 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, which are China and Argentina respectively. There is also an evidence of liquidity spillovers from the U.S. equity market to domestic bond markets around the world. Employing a conditional model, which allows both time-series and crosssectional variations 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 modest. The third research paper examines whether liquidity spillovers between sovereign bonds are systematic or idiosyncratic in character. A theoretical model is developed, which demonstrates that idiosyncratic spillovers require returns to be correlated, whereas systematic spillovers require volatilities to be correlated. We apply the model to sovereign bonds in 35 emerging markets, aggregated for some analyses into Asian, European and Latin American regions. We find liquidity spillovers mainly from Latin America to the other regions and they are both systematic and idiosyncratic in character. Further cross-sectional analysis (by country) and time-series analysis (by region) show that systematic spillovers are more important than idiosyncratic spillovers. The conclusion is that most liquidity risk across emerging bond markets is systematic and therefore cannot easily be hedged away. This has important implications for portfolio selection by fund managers and for the regulation of systemic risk.