Valuation, Liquidity and Risk in Government Bonds, Liquidity and Limits to Arbitrage

We explore the determinants of yield differentials between 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 depend on the size of the liquidity differential with respect to the reference country. Testing these predictions on daily data, we find that the international risk factor is consistently priced, while liquidity differentials are priced for a subset of countries and their interaction with the risk factor is crucial to detect their effect.