Valuation, Liquidity and Risk in Government Bond Markets Carlo Favero Marco Pagano Ernst-Ludwig von Thadden March 8, 2004 (first draft)

We explore the determinants of yield differentials between long-term sovereign bonds in the Euro area. There is a common trend in yield differentials, which is correlated with a measure of the international risk factor. In contrast, liquidity differentials display sizeable heterogeneity and no common factor. We present a model that predicts that yield differentials should increase in both liquidity and risk, with an interaction term whose magnitude and sign depends on the size of the liquidity differential with respect to the reference country. Upon testing these predictions on daily data, we find that the international risk factor is consistently priced, while liquidity differentials are priced only for a subset of countries and their interaction with the risk factor is crucial to detect their effect. JEL classification numbers: E43, G12. Acknowledgements: We thank the Fondation Banque de France, for providing the main source of funding for this project. Additional financial support has been kindly provided by Inquire. We are grateful to Euro MTS, and in particular to its CEO, Gianluca Garbi, for supplying the data. Stephan Maier and Michele Galietta provided able research assistance.