Price of future liquidity: time-varying liquidity in the U.S. Treasury market

Goldreich, CD, Hanke, B and Nath, P (2003) Price of future liquidity: time-varying liquidity in the U.S. Treasury market. Working Paper. London Business School IFA Working Paper.

Abstract

This paper examines the price differences between very liquid ontherun U.S. Treasury securities and less liquid offtherun securitites over the entire on/off cycle. Unlike previous studies, by comparing pairs of securities as their relative liquidity varies over time, we can disregard any crosssectional differences between the securities. Also, since the liquidity of Treasury notes varies predictably over time we are able to distinguish between current liquidity and expected future liquidity. We show that the more liquid security is priced higher on average, but that this difference depends on the amount of expected future liquidity over its remaining lifetime rather than its current liquidity. We measure future liquidity using both quotes and trades. The liquidity measures include bidask spread, depth and trading activity. Examining a variety of liquidity measures enables us to evaluate their relative importance and to identify the liquidity proxies that most affect prices. Although all the measures are highly correlated with one another, we find that quoted bidask spread and quoted depth are more important than effective spread and trade size, respectively. However, among measures of market activitiy, the number of trades and volume are more related to the liquidity premium than the number of quotes.