The Price of Future Liquidity : Time-Varying Liquidity in the U.S. Treasury Market

This paper examines the price differences between very liquid on-the-run U.S. Treasury securities and less liquid off-the-run securities over the entire on/off cycle. By comparing pairs of securities as their relative liquidity varies over time we can disregard any cross-sectional differences between the securities. Since the liquidity varies predictably over time we are able to differentiate between current liquidity and expected future liquidity. We show that the more liquid security is priced higher on average, but that this difference depends on the amount of expected future liquidity over its remaining lifetime rather than its current liquidity. We measure future liquidity using both quotes and trades. The measures include bid-ask spread, depth and trading activity. Examining a variety of liquidity measures enables us to evaluate their relative importance and identify the liquidity proxies that most affect prices. Although all of the measures are highly correlated with one another, we find that quotes are more important when estimating the effect of the bid-ask spread and depth on the liquidity premium, while the number of trades and trading volume is a more important measure of market activity than the number of quotes