Exploring Traded Volatility In The Swap Market To Explain Disparities Between Liquidity Risk Premiums

Sammanfattning

This thesis studies the liquidity risk premiums that investors should demand on municipal bonds, that are less liquid than government bonds. First, a simple regression study is performed, showing a correlation between the interest rate spread between the two types of bonds, and the forward-looking volatility in the swap market. This implies that investors should demand an increased premium in times of higher uncertainty. The liquidity risk premium is analyzed further in the main part of the thesis, particularly in the scenario where investors are unable to sell a municipal bond on the market. Here, the liquidity risk premium is modeled through the one-factor stochastic short-rate model known as the Vasicek Model. The modeled spread, compared to the actual spread between the two types of bonds, is larger, implying that investors should demand a higher premium on the less liquid municipal bond than is actually demanded on the market.