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2001 Documento de Trabajo #105

A Liquidity Premium Puzzle?: Evidence from Chile

From the early 1980.s until the late 1990.s the term structure of interest rates in Chile was usually downward sloping, particularly for long maturities. Although this fact was common knowledge, no one attempted to explain formally the reason why of this phenomenon. We postulate that the explanation is behind liquidity premium of the term structure of interest rates. Based upon a parsimonious theoretical model, we show that the sign of liquidity premium depends on both expected return and risk. For our sample period 1983-1999, liquidity premium was negative about 50 percent of the time, and when positive it was very small. This implies that investors were willing to hold long-term assets even though their return was relatively lower. This appeared to be a consequence of the indexation of the Chilean economy, which reduced risk of long-term bonds as their return was linked to past inflation. The existence of a negative liquidity premium would explain why the term structure of interest rates in Chile was downward sloping for long maturities over our sample period. Data of spreads of Central Bank indexed bonds show that these were usually negative over January 1994-December 1998. However, since 2000 onwards, spreads have switched sign due to an expansionary monetary policy. As a consequence, the term structure has become upward sloping for short maturities, and rather flat for longer maturities. At the same time, a declining inflation rate has made inflation-linked bonds less attractive than before.

Viviana Fernández