We provide a model to estimate bond liquidity costs using only daily prices. Our liquidity estimates are 30% correlated with the bid-ask spread and are within five basis points of the bid-ask spread for investment grade bonds. Our median liquidity estimates are approximately $0.15 for investment grade bonds which compares well with those established by Schultz (2001) or Hong and Warga (2000). Regression tests indicate that our estimate of liquidity is associated with the bid-ask spread even after controlling for the commonly used liquidity determinants. Assessing the economic significance of our liquidity estimate in relation to the yield spread, we find that our estimate of liquidity is positively associated with the yield spread regardless of controlling for the commonly used yield spread determinants. These results imply that liquidity costs exact an demonstrable influence on bond returns and are consequently a priced element of the yield spread.
Corporate bond trading on exchange listed and over-the counter markets now exceeds $15 billion per day.1 Affecting these markets is the underlying liquidity that is of increasing concern to regulators, bond traders2 , and academicians. However, arguments concerning liquidity are often muted because of the complex problems of implementing liquidity aspects into empirical pricing analysis. Recent studies, Schultz (2001) and Hong and Warga (2000), highlight the obstacles in estimating the costs of trading corporate bonds, while Longstaff (2000) outlines the difficulties in incorporating liquidity into bond yield studies.3 While a comprehensive estimate of liquidity costs for corporate bonds is crucial for studying investment strategies and understanding bond yields, such an estimate is lacking in current empirical studies. This paper attempts to fill this void by presenting an empirical model to estimate bond liquidity and by assessing the economic significance of the relationship between liquidity and bond yields.
You will see this theme throughout this book. It is the most important concept you can learn in order to be a successful trader. If you can master this skill, you can be very successful in this business. But without it, you are destined to fail. It really is that simple. If you can learn to act in your own best interest, you will make a lot of money trading. If you do not learn to act in your own best interest, you will lose a lot of money trading.
The literature has in general taken the model of capital accumulation with a unique final consumption good as a canonical framework to study the patterns of economic growth. In particular, this model has been widely used to analyze the dynamic effects of shocksin fundaments and, in special, for the economic policy analysis.
The main feature of this model is that the economic dynamics is fully driven by the returns to capital. As the seminal contribution of Ramsey (1928) states, the optimal intertemporal allocation of consumption and investment leads the growth of consumption expenditure to only depend on the net interest rate. In this paper we assert that this standard result can not be generalized to models that allow for several heterogeneous consumption goods. More precisely, the aforementioned benchmark model may be not appropriate to study the dynamic effects of those shocks that have permanent effect on the sectoral composition of consumption. To show this point, we characterize the properties of the transitional dynamics of a growth model where individuals derive utility from the consumption of two heterogeneous goods.
