Price informativeness and predictability: how liquidity can help

Lin, William and Tsai, Shih-Chuan and Sun, David (2008): Price informativeness and predictability: how liquidity can help. Published in: Applied Economics , Vol. 17, No. 43 (July 2011): pp. 2199-2217.

Abstract

Information asymmetry and liquidity concentration has been widely discussed in literatures. This study shows how liquidity influences not only forecasting performances of term structure estimation, but also information transmission and price adjustment across markets. Our analysis helps understanding how extreme market movements affect one another. This study examines, and provides a rationale for incorporating, liquidity in estimating term structure. Forecasting performance can be greatly enhanced when conditioning on trading liquidity. It reduces information asymmetry in the sense of Easley and O’Hara (2004) and Burlacu, Fontaine and Jimenez-Garces (2007). We adopt a time series forecasting model following Diebold and Li (2006) to compare behavior of forecasted price errors. Our findings indicate that forecasted price errors in markets with less depth would influence those with more. Information asymmetry induces volatile trading first and then price adjustment is transmitted to another market due to insufficient market depth. Cross-market price adjustment could be as much as 21 bps on average. Compared with previous studies, our results establish a valid reason to condition on liquidity when forecasting prices.

• Item Type: MPRA Paper
• Language: English
• Keywords: Liquidity; Trading Concentration; Information Asymmetry; Information Transmission; Yield Curve Fitting
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Interest Rates: Determination, Term Structure, and Effects; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D82 - Asymmetric and Private Information ; Mechanism Design; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E47 - Forecasting and Simulation: Models and Applications

References

Alonso, F., R. Blanco., A. Del Rio and A. Sanchis, 2004, “Estimating Liquidity Premia in Spanish Government Securities Market.” European Journal of Finance 10, 453-474.

Amihud, Y., 2002, “Illiquidity and stock returns: cross-section and time-series effects,” Journal of Financial Markets, 5, 31-56.

Amihud, Y. and H. Mendelson, 1991, “Liquidity, Maturity, and the Yields on U.S Treasury Securities,” Journal of Finance, 46(4), 1411-1425.

Burlacu, R., P. Fontaine and S. Jimenez-Garces, 2007, “Measuring Private Information in a Rational Expectations Framework,” C.E.R.A.G – UMR CNRS 5820 and EUROFIDAI-UMS CRNS 2748, Université Pierre Mendès France.

Bliss, R.R., 1997, “Testing Term Structure Estimation Methods.” Advances in Futures and Option Research 9, 197-232.

Bolder, D.J. and D. Streliski, 1999, “Yield Curve Modelling at the Bank of Canada,” Bank of Canada Technical Report 84.

Brandt, M., and K. Kavajecz, 2004, “Price Discovery in the U.S. Treasury Market: The Impact of Order Flow and Liquidity on the Yield Curve,” Journal of Finance, 59, 2623-2654.

Dai, Q. and K. Singleton, 2003, “Term Structure Dynamics in Theory and Reality,” Review of Financial Studies, 16(3), 631-678.

Darbha, G., 2004, “Estimating the Benchmark Yield Curve: A New Approach Using Stochastic Frontier Functions.” Working Paper, Rodney L. White Center for Financial Research.

Datta, S., and M. I. Datta, 1996, “Does Insider Trading Have Information Content for the Bond Market?” Journal of Banking and Finance 20, 555-575

Diaz, A., J. Merrick, Jr., and E. Navarro, 2006, “Spanish Treasury Bond Market Liquidity and Volatility pre- and post-European Monetary Union.” Journal of Banking and Finance 30, 1309-1332.

Diebold, F. and C. Li, 2006, “Forecasting the Term Structure of Government Bond Yields,” Journal of Econometrics 130(2), 337-364.

Dolan, C., 1999, “Forecasting the Yield Curve Shape: Evidence form Global Markets,” Journal of Fixed Income, June, 9(2), 92-99

Duarte, J. and L. Young, 2008, “Why is PIN priced?” forthcoming in Journal of Financial Economics. Duffie, D, N. Garleanu, and L.H. Pedersen, 2005, “Over-The-Counter Markets,” Econometrica, 73(6), 1815-1847.

Dutta, G., S. Basu and K. Vaidyanathan, 2005, “Term Structure Estimation in Illiquid Government Bond Markets: An Empirical Analysis,” Journal of Emerging Market Finance 4, 63-80.

Easley, D., S. Hvidkjaer, and M. O’Hara, 2002, “Is Information Risk a Determinant of Asset Returns,” Journal of Finance, 52(5), 2185-2221.

Easley, D., and M. O’Hara, 2004, “Information and the cost of capital,” Journal of Finance, 59, 1553-1583.

Elton, E.J. and T.C. Green, 1998, “Tax and Liquidity Effects in Pricing Government Bonds,” Journal of Finance, 53(5), 1532-1562.

Eom, Y., M. Subrahmanyam, and J. Uno, 2002, “Transmission of Swap Spreads and Volatilities in the Japanese Swap Market,” Journal of Fixed Income 12, 6-28.

Favero, C.A., L. Niu, and L. Sala, 2007, “Term Structure Forecasting: No-Arbitrage Restrictions vs Large Information Set,” CEPR Discussion Papers 6206.

Fleming, M., 2003, “Measuring Treasury Market Liquidity,” FBNY Economic Policy Review 83-108.

Goldreich, D., B. Hanke, and P. Nath, 2005, “The Price of Future Liquidity: Time-Varying Liquidity in the US Treasury Market,” Review of Finance 9, 1-32.

Goyenko, R., A. Subrahmanyam, and A. Ukhov, 2008, “The Term Structure of Bond Market Liquidity,” Working Paper, McGill University.

Green, C., 2004, “Economic News and the Impact of Trading on Bond Prices,” Journal of Finance 59, 1201-1233.

Henker, T., and J. Wang, 2006, “On the Importance of Timing Specifications in Market Microstructure Research,” , Journal of Financial Markets, 9(2), 162-179.

Longstaff, F.A., 2004, “The Flight-To-Liquidity Premium in U.S. Treasury Bond Prices,” Journal of Business 77(3) 511-526.

Lin, W., and D. Sun, 2007, “Liquidity-Adjusted Benchmark Yield Curve: A Look at Trading Concentration and Information,” Review of Pacific Basin Financial Markets and Policies, 10(4), 491-518.

Nelson, C.R. and A.F. Siegel, 1987, “Parsimonious Modeling of Yield Curves,” Journal of Business 60(4), 473-489.

Reisman, H., and G. Zohar, 2004, “Short Term Predictability of the Term Structure,” Journal of Fixed Income, 14(3), 7-14.

Sarig, O., and A. D. Warga, 1989, “Bond Price Data and Bond Market Liquidity,” Journal of Financial and Quantitative Analysis 24, 367-378.

Shen, P. and R.M. Starr, 1998, “Liquidity of the Treasury Bill Market and the Term Structure of Interest Rates,” Journal of Economics and Business 50(5), 401-417.

Subramanian, K.V., 2001, “Term Structure Estimation in Illiquid Markets.” Journal of Fixed Income 11(2), 77-86.

Svensson, L.O., 1994, “Estimating Forward Interest Rates with the Extended Nelson and Siegel Method,” Sveriges Riksbank Quarterly Review, 3, 13-26.

Vayanos, D. and T. Wang, 2007, “Search and Endogenous Concentration of Liquidity in Asset Markets,” Journal of Economic Theory, 136, 66-104.

Waggoner, F.D., 1997, “Spline Methods for Extracting Interest Rate Curves from Coupon Bond Prices,” Working Paper 97-10, Federal Reserve Bank of Atlanta.

Yuan, K., 2005, “The Liquidity Service of Benchmark Securities,” Journal of the European Economic Association 3(5), 1156-1180.

Zhou, X., 2007 “Information, Liquidity and Corporate Yield Spreads,” Working Paper, Rutgers University.