Determinants Of Government Bond Yield In Eurozone

Liquidity is one of the main characters of financial assets, and is also one of the prerequisites of the sound function of security market. Furthermore, liquidity is one of the determinants of asset pricing and security yield as well. There have already been a large number of analyses concerning the impact of liquidity on government bond yield, however, due to the difference in the selection of sample and proxy variable, different studies can usually achieve divergent or even contradictory results. In order to study the influence of liquidity, one cannot fail to consider the combined effect of credit quality, common risk conditions and other risk factors. Moreover, each risk factor even plays a different role in the determination of government bond yields in different times and different countries.This paper first reviews two classical asset pricing models:CAPM and APT, then studies the applicability of these models in pricing government bonds. Based on CAPM and APT, several relevant risk factors are raised and studied. Later on, with the help of previous studies, I establish an inter-temporal baseline model and consider the impact of common risk conditions on investor decisions. In this model, I also introduce a new variable-the joint effect of liquidity and common risk factor.In the empirical analysis, this paper selects five representative countries in the euro zone, which are also the countries with largest government bond issuance. Setting German Bund as benchmark, I analyze the influence of each risk factor on the government bond yield spreads from July30,2009to July13,2012. Result shows that common risk factor and credit condition both have significantly positive influence in determining yield spreads. It is interesting to notice that liquidity alone does not have any significant explanatory power, but the joint effect is significant, suggesting the indirect relationship between liquidity and bond yield. Moreover, a closer look at the country-specific results from different sub-sample periods shows that liquidity’s influence towards bond yield also varies in countries and time. The model functions most properly in the stable and consistent markets like France and the Netherlands, but when it comes to low-creditworthy countries like Italy and Spain, there exists obvious difference in its explanatory power. In the former group, common risk factor plays a major role in determining government bond yield, while in the latter, credit risk factor dominates.