Valuation, Liquidity and Risk in Government Bond Markets

We explore the determinants of yield differentials between long-term sovereigen bonds in Europa area. There is a common trend in yield differentials, which is correlated with the measure of tghe international risk factor. In contrast, liquidity differentials display sizeable hetrogeneity and no common factor. We present a model that predicts that yield differentials should increase in both liquidity and risk, with an interaction term whosemagnitude and sign depends on the size of the liquidity differntial with respect to the reference country. Upon testing these predictions on daily data, we find that the international risk factor is consistently priced, while liquidity differentials are priced only for a subset of countries and their interaction with the risk factor is crucial to detect their effect.