Liquidity Premium Effect In China’s Interbank Bond Market

Liquidity premium can be defined as the compensation investors get because of the cost due to liquidity risk. Among many studies on liquidity, research on liquidity premium effect has been a hot topic for scholars, and research on liquidity premium has important significance for both the theory and practice. However, there is seldom research on China’s interbank bond market. In recent years, while the trading volume of interbank bond market has been growing rapidly, the ability of price discovery and market pricing becomes a very important issue. In the meantime, liquidity premium, as part of pricing is of great significance. Besides, the development of market maker mechanism could guarantee the validity of bid-ask spread designated as a liquidity indicator. The author selected Treasury bond market and political financial bond market as research objects, which account for more than half of the total trading volume.This article uses two methods trying to test the existence of the liquidity premium effect using bid-ask spread as illiquidity indicator and reciprocal of bid-ask spread as well as turnover rate as liquidity indicators. One is to divide bonds into liquid and illiquid, and then to investigate the relationship between liquidity difference and yield difference between liquid bond and the corresponding illiquid bond with same term structure of interest rates. The other is to build a linear regression model by calculating the difference between actual yield and theoretical yield from Nelson-Siegel model, using liquidity variables as explanatory variables and tax variables as control variables. The author draws the conclusion that Treasury bonds and political financial bonds in interbank bond market do have liquidity premium, and author also finds that the degree liquidity could affect yields different among different bond categories. This article further proves that how much liquidity could influence yield is dependent on investors’ structure, and the higher the trading institutions proportion is, the greater the yield changes caused by unit of liquidity changes. Finally, this article further gives suggestion on promoting liquidity pricing ability.