Bond Liquidity Premia

Asset pricing models of limits to arbitrage emphasize the role of funding conditions faced by financial intermediaries. In the US, the Treasury repo market is the key funding market and, hence, theory predicts that the liquidity premium of Treasury bonds share a funding liquidity component with risk premia in other markets. This paper identifies and measures the value of funding liquidity from the cross-section of bonds by adding a liquidity factor correlated with age to an arbitrage-free term structure model. A revisited version of this paper was published in the April 2012 issue of The Review of Financial Studies.