The missing piece of the puzzle: Liquidity premiums in inflation-indexed markets

We show that in both index-linked bond markets and inflation swap markets liquidity is an important determinant of prices. We do so by means of an asset pricing model with a liquidity risk factor and asset-specific liquidity characteristics. This liquidity risk factor is based on the measures of Amihud (2002) and Roll (1984). The level of liquidity is proxied by asset-level characteristics such as age and amount issued. Using US data, we find strong evidence that the level of liquidity, in contrast to liquidity risk, affects yields on inflationindexed bonds, whereas inflation swap yields include a liquidity risk premium. We also study liquidity effects in nominal bonds in a similar way, which allows us to study the apparent mispricing between indexed bonds, inflation swaps and nominal Treasuries (Fleckenstein et al (2013)). We find that liquidity premiums explain a substantial part of this mispricing.