Term Structure Estimation, Liquidity-Induced Heteroskedasticity and the Price of Liquidity Risk

27 Pages Posted: 25 Apr 2014

See all articles by Emma Berenguer

Emma Berenguer

Universidad Pablo de Olavide

Ricardo Gimeno

Banco de España

Juan M. Nave

Universidad de Castilla - La Mancha

Date Written: April 24, 2014

Abstract

Since the seminal paper of Vasicek and Fong (1982), the term structures of interest rates have been fitted assuming that yields are cross-sectionally homoskedastic. We show that this assumption does not hold when there are differences in liquidity, even for bonds of the same issuer. Lower turnover implies higher volatility. In addition, a minimum tick size for bond price negotiation will produce higher volatility for bonds approaching their maturity dates. To show these effects, we use data for Spanish sovereign bonds from 1988 to 2010, covering more than 700 bonds and 5000 trading days. We estimate the out-of-sample error for each bond and day. The variance of these errors is found to be negatively correlated with each bond’s turnover and duration, while the mean of the errors is found to be directly correlated with the estimated variance. As a result, we propose a modified Svensson (1994) yield curve model to fit the term structure, adding a liquidity term and estimating parameters by weighted least-squared errors to take into account the liquidity-induced heteroskedasticity.

Keywords: heteroskedasticity; liquidity premium; yield curve fitting; Spanish sovereign bonds

JEL Classification: G12, C58, E43

Suggested Citation

Berenguer, Emma and Gimeno, Ricardo and Nave, Juan M., Term Structure Estimation, Liquidity-Induced Heteroskedasticity and the Price of Liquidity Risk (April 24, 2014). Banco de Espana Working Paper No. 1308, Available at SSRN: https://ssrn.com/abstract=2428640 or http://dx.doi.org/10.2139/ssrn.2428640

Emma Berenguer (Contact Author)

Universidad Pablo de Olavide ( email )

Ctra. Utrera, Km.1
Sevilla, Seville 41010
Spain

Ricardo Gimeno

Banco de España ( email )

Madrid 28014
Spain

Juan M. Nave

Universidad de Castilla - La Mancha ( email )

Facultad de Ciencias Sociales
Avda. de los Alfares, 44
CUENCA, CUENCA 16071
Spain

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
102
Abstract Views
785
Rank
472,796
PlumX Metrics