Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads

By Krista Schwarz. 2018

242 citations recorded by the source corpus.

Wide and volatile interest rate spreads in the 2007-2009 financial crisis could represent concerns over asset liquidity or issuer solvency. To precisely identify the contribution of these two effects on sovereign bond and interbank spreads, I propose a model-free measure of euro-area market liquidity, and a measure of near-term interbank default risk. I find that credit and liquidity are independently important. In interbank risk spreads, the role of liquidity dominates, while the importance in sovereign bond yield spreads varies substantially by country and maturity. To better understand the liquidity channel that is captured by the new liquidity measure, but is understated by extant measures, I test the pricing of liquidity risk; the possibility that liquidity could be negatively correlated with marginal utility. I exploit the variation in returns over countries, maturities and time, and find that liquidity euro-area sovereign bond risk premia are large and significant.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/4965391ff26df70a993d922bead4c2e37a56efe2

Citations in the corpus

• A model of liquidity hoarding and term premia in inter-bank markets (2011, unknown): “…LIBOR-OIS spreads (as shown in Figure 1) primarily to counterparty credit risk, McAndrews, Sarkar and Wang (2008), Michaud and Upper (2008) and Schwarz (2009) attribute most of the spread to liquidity risk, whereas Smith (2010) argues that time-varying risk premia explain half of the…”
• Money creation and the shadow banking system (2015, unknown): “Thus, OIS contracts carry little credit risk and are a good proxy for risk-free rates purged of liquidity and credit risk premia (Brunnermeier, 2009; Duffi e and Choudry, 2011; Feldhutter and Lando, 2008; Gorton and Metrick, 2010a; Schwarz, 2010 ).”
• Deviations from Covered Interest Rate Parity (2018, unknown): “Schwartz (2015) provides more details on the KfW bonds, comparing them to German government bonds to study their liquidity premium.”
• Euro Area Sovereign Risk During the Crisis (2009, unknown): “Recently—and in line with Beber and others (2009), Schwarz (2009), and ECB (2009)—Manganelli and Wolswijk (2009) find that liquidity can explain nearly half the spread and that the liquidity premiums tend to be high when interest rates are high.”
• The Term Structure of Interbank Risk (2012, unknown): “34 In her analysis of the three-month EURIBOR-OIS spread, Schwartz (2010) uses a similar spread between yields on KfW bonds (guaranteed by the German government) and German government bonds as a proxy for liquidity.”
• Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk (2009, unknown): “Both full participation and adverse selection in the interbank market coexist as equilibria if conditions (42) and (38) hold.”
• ECB Policies Involving Government Bond Purchases: Impact and Channels (2017, unknown): “We use daily changes in the yield spread between German government bonds (Bunds) and German agency bonds (KfW) as a liquidity risk factor as in Schwarz (2010). We then estimate liquidity-risk related yield movements in the event windows as the liquidity betas multiplied by the change in the KfW-Bund”