Liquidity in the EMU benchmark government bond market: the role of interest rate volatility.

Abstract

This paper measures the liquidity of government bonds of the countries that participate in European Monetary Union and particularly how the introduction of the euro may have affected the liquidity conditions in the bond market in each country. It also examines whether the volatility of the interest rates and the participation of the foreign investors in the government bond market had any liquidity effect. Specifically this study examines bonds from Germany, Italy, France, Spain, Portugal, Belgium, Netherlands, Ireland, Finland and Austria. It examines the ten year bonds for the on-the-run issues because generally these bonds are used as benchmarks and because they are the most homogenous bonds with common characteristics and that makes easier the comparison both across time and across countries. The European Monetary Union took place at January 1999, so this study examines the pre 1999 period and the period after the 1999 monetary convergence. More specifically it takes the period from July 1996 up to June 1998, and the period from July 1999 till June 2001. The data for the bid ask spread is daily and it is taken from Bloomberg. For the volatility of the interest was used the standard deviation of the daily changes of the ten year benchmark bond yield curves. This paper tries to examine the relation between interest rate volatility and liquidity. It also tries to examine the relation between liquidity with interest rate volatility and foreign debt ratio together. The foreign debt ratio is defined as the ratio of the debt held by non residents to the total vernment debt.