How Important Is Liquidity Risk for Sovereign Bond Risk Premia? Evidence from the London Stock Exchange

This paper uses the framework of arbitrage-pricing theory to study the relationship between liquidity risk and sovereign bond risk premia. The London Stock Exchange in the late 19th century is an ideal laboratory in which to test the proposition that liquidity risk affects the price of sovereign debt. This period was the last time that the debt of a heterogeneous set of countries was traded in a centralized location and that a sufficiently long time series of observable bond prices are available to conduct asset-pricing tests. Empirical analysis of these data establishes three new results. First, sovereign bonds with wide bid-ask spreads earn 3-4% more per year than bonds with narrow bid-ask spreads, and the difference is reflected in greater sensitivity to innovations in market liquidity. Second, small sovereign bonds, as measured by market value, earn 1.8-3.5% more per year than large sovereign bonds, and the difference is also reflected in their exposure to innovations in market liquidity. Third, market liquidity is a state variable important for pricing the cross-section of sovereign bonds. This paper thus provides estimates of the quantitative importance of liquidity risk as a determinant of the sovereign risk premium and underscores the significance of market liquidity as a nondiversifiable risk.

Published In:

Journal of International Economics (0022-1996)
November 2010. Vol. 82, Iss. 2, pp. 219-229