Liquidity and its impact on bond prices

In this paper, we propose a theoretical continuous-time model to analyze the impact of liquidity on bond prices. This model prices illiquid bonds relative to liquid bonds and provides a testable theory of illiquidity induced price discounts. The model is tested using 1992-1994 data from bonds issued by the german government.These bonds define a market segment that is homogeneous in bankruptcy risk, taxes, age, and coupons, but the bonds differ with respect to their liquidity. The empirical findings suggest that bond prices not only depend on the dynamics of interest rates, but also on the liquidity of bonds. Therefore, bond liquidity should be used as an additional pricing factor. The findings of the out-of-sample test demonstrate the superiority of the model in comparison with traditional pricing models.