Interpretable Liquidity Proxy in Fixed Income Markets and Application to the TIPS Market

A Robust and Interpretable Liquidity Proxy: In this paper we provide an operational definition of market and funding liquidity, and we introduce a method to create two corresponding liquidity measures. The construction is based on creating two parsimonious linear combinations of many liquidity proxies often used in the literature. We manage to attribute a precise financial interpretation to our two liquidity measures delineated by the speed of mean-reversion, and associate them with the known market liquidity and funding liquidity terms. Our construction does not require transaction-level data (such as volume or bid-offer spreads), and correlates well both with other measures that do, and with the liquidity as “noise”, liquidity as broker-dealer leverage, both of which have been recently added to the literature. We show our liquidity risk measures are robust in estimation, and can potentially price a range of assets, and present an application to explain several persistent frictions in the Fixed-Income market.
 

The Role of Liquidity in Pricing of TIPS: Estimating the liquidity contribution in the Break-Even Inflation spread and the inflation basis spread, we study the pricing dynamics of US Treasury nominal, inflation protected bonds and the inflation swap rates, under normal and stressful market conditions. We present robust empirical evidence illustrating that liquidity risk premium varies cross-sectionally and across time. With known systemic liquidity measures and latent mean-reverting Treasury risk factors estimated with Affine Term Structure model, we affirm the risk transmission mechanism in Treasury market differs from that in risky assets, and TIPS are only a “partial-haven” asset. We confirm significant and specific illquidity risk premium priced in the inflation swaps, and find the “bond puzzle” phenomenon persists largely attributable to the limited balance sheet capacity and the lack of a perfect replicatability to arbitrage under current inflation market structure.