Microsoft Word - Money, Banking, and Int Finance(scribd).docx

Money, Banking, and International Finance

Corporate Bonds U.S. Government Bonds

Figure 1. Impact of a risk premium on the bond markets

Liquidity and Bond Prices

Liquidity causes bond prices and interest rates to differ. For instance, U.S. government
securities are widely traded and are the most liquid. Hence, investors can buy and sell them. On
the other hand, corporate bonds are not as liquid and not as widely traded, so investors have
more difficulties in buying and selling them. Consequently, we use a similar analysis to default
risk, which we have explained in the previous section. We start the analysis with the same
liquidity in both the government bond and corporate bond markets in Figure 2. Thus, both bond
markets have the identical equilibrium bond price, P*, and hence, the exact liquidity.
Then the secondary markets expand for government bonds boosting the liquidity for these
securities. Consequently, the investors are attracted to the government bonds because they are
more liquid. Demand function increases and shifts rightward for government bonds. However,
investors reduce their purchases of corporate bonds because they are less liquid, decreasing the
demand function and shifting it leftward. Thus, the government bond prices rise, which reduces
the interest rate for government bonds. On the other hand, the corporate bond prices decrease,
raising the market interest rate for corporate bond. Taking the difference between the two
interest rates, we measure the degree of liquidity. Nevertheless, economists refer the difference
in interest rates as a risk premium.