A Liquidity Premium Puzzle?: Evidence from Chile

This article looks at the determinants of liquidity premium of the term structure of interest rates. Based upon a very simple model, we show that liquidity premium is not necessarily positive, as usually believed. This point is illustrated empirically with Chilean data for the sample period 1983-1999. Our estimation results show that liquidity premium is not only time-varying but that it also depends on the curvature of the term structure, expected inflation, expected depreciation of the nominal exchange rate, and on economic activity, contradicting the expectations hypothesis. For our sample period, the liquidity premium is usually negative, and when positive it is very small. This implies that investors are willing to hold long-term assets even though their return is relatively lower. This appears to be a consequence of indexation, which reduces the risk of long-term bonds as their return is linked to past inflation. Alternatively, we believe that a negative liquidity premium may be explained by the preferred habitat hypothesis of interest rates. Indeed, data on the composition of the portfolios of Chilean insurance and re-insurance companies show that, due to immunization (matching of durations of assets and liabilities), about a 60 percent of total assets correspond with long-term bonds and mortgage securities. This investment strategy drives the prices of long-term financial instruments up, and their rates down.