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How does liquidity shape the yield curve?

Author

Listed:
  • Victor Le Coz

    (LadHyX - Laboratoire d'hydrodynamique - X - École polytechnique - IP Paris - Institut Polytechnique de Paris - CNRS - Centre National de la Recherche Scientifique)

  • Iacopo Mastromatteo
  • Michael Benzaquen

    (LadHyX - Laboratoire d'hydrodynamique - X - École polytechnique - IP Paris - Institut Polytechnique de Paris - CNRS - Centre National de la Recherche Scientifique)

Abstract

The phenomenology of the forward rate curve (FRC) can be accurately understood by the fluctuations of a stiff elastic string (Le Coz and Bouchaud, 2024). By relating the exogenous shocks driving such fluctuations to the surprises in the order flows, we elevate the model from purely describing price variations to a microstructural model that incorporates the joint dynamics of prices and order flows, accounting for both impact and cross-impact effects. Remarkably, this framework allows for at least the same explanatory power as existing cross-impact models, while using significantly fewer parameters. In addition, our model generates liquidity-dependent correlations between the forward rate of one tenor and the order flow of another, consistent with recent empirical findings. We show that the model also account for the non-martingale behavior of prices at short timescales.

Suggested Citation

  • Victor Le Coz & Iacopo Mastromatteo & Michael Benzaquen, 2024. "How does liquidity shape the yield curve?," Working Papers hal-04735468, HAL.
    • Handle: RePEc:hal:wpaper:hal-04735468
    Note: View the original document on HAL open archive server: https://hal.science/hal-04735468v1
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