Sovereign Bonds in Emerging Asia: Do Investors Demand Liquidity Premium?

Abstract

This study explores how liquidity premium is priced in emerging bond markets and has implications for the investors, because these markets exhibit lower liquidity levels and behave differently from the developed West. Liquidity risk epitomizes higher trading costs, lower trading speed, and higher price impact of large trades. The study investigates pricing implications of these liquidity dimensions across a wide term structure of sovereign bonds. We also identify the most prominent liquidity component that causes yield spread changes and drives investment decisions. Our study comprises nine bond classes, ranging from 3-month to 10-year bonds, across six emerging Asian markets. We observe that the liquidity risk increases along with the term to maturity of the bond. Our empirical results reveal that the price impact dimension is vital for short-term investments. The trading cost and trading frequency dimensions are priced in the medium-term and long-term bonds. It was also observed that investors consider the trading cost as a more important element than the trading frequency and price impact dimensions.

TOPICS: Emerging markets, project finance, statistical methods, credit risk management

Key Findings

• • Liquidity risk increases with the term to maturity of the bond.

• • Higher price impact generated by large trades is found to determine investment decisions in short-term bonds while trading cost and frequency are found important for medium- and long-term investments.

• • In general, investors consider trading cost as a more important element than other dimensions of liquidity while investing in emerging markets.