Estimating Bond Liquidity

Liquidity significantly affects bond prices, yet this variable remains little understood. This paper gives a definition and measure of bond liquidity, and shows why it tends to decay over time. A model of bid-ask spreads as a function of term, price and liquidity is then developed. It is used to estimate the liquidity of individual U.S. Treasury bonds during 1987-1990. The pattern of liquidity decay is illuminated by regressing these estimates on age and quantity outstanding.