This paper studies the effects of time-varying liquidity on Italian government bond yields. Moreover, it proposes a new methodology to estimate the liquidity premium through analysis of the spread between the yield on the most recently issued BTP (on-the-run) and that on the previously issued BTP (off-the-run) in relationship to several liquidity metrics proposed in the literature.
Results confirm that the on- and off-the-run spread is highly influenced by market liquidity conditions, as measured in particular by the bid-ask spread, the Hui-Heubel indicator (a price impact measure) and volumes. Between 2000 and 2021, the liquidity premium was small on average, although it recorded three peaks during the global financial crisis, the sovereign debt crisis and the Covid-19 pandemic.
