Liquidity Unveiled: Crafting an Index to Decode the Sovereign Bond Market Risk

Abstract

Liquidity risk poses a distinctive and multifaceted challenge in the financial arena owing to its underlying multiple dimensions. The long-term 10-year bonds exhibit high trading activity, as evidenced by the trading frequency dimension, while the trading cost dimension and existing literature support the view that short-term bonds tend to be more liquid. In this study, the objective is to address this intricacy and explore the potential commonality across various liquidity dimensions. This is done by constructing an index of liquidity risk that stands independently from these dimensions. The liquidity risk index is formed by combining the major dimensions of liquidity: price impact, trading cost, and trading frequency, resulting in a single measure of liquidity risk. Using the first principal component extraction method, the illiquidity index is studied in a sample of six emerging Asian countries. The findings indicate that the principal component (PCA) index effectively measures aggregate liquidity risk. On the pricing dynamics, it is seen that that the PCA index is significantly affecting the yield spread of bonds with a maturity of 1-year and greater. For the 3-month and 6-month bonds, the illiquidity index fails to produce any significant impact. The study thus highlights that long and medium-term investors in bonds are more concerned with liquidity risk compared to short-term investors.