Academic journal article Financial Management

The Effect of Substitute Assets on Yields in Financial Markets

Academic journal article Financial Management

The Effect of Substitute Assets on Yields in Financial Markets

Article excerpt

We examine the link between volume and liquidity in money markets where there are close substitutes. We find that the size of the market, as a proxy for trading volume, affects yield spreads over T-bill rates. We examine the bankers acceptances market, when market size declined by half over the decade of the 1990s. Controlling for interest-rate levels, day-of-the-week, calendar, term structure, credit spread, time-series, and cross-equation effects, we find that the substitution effect does not eliminate the impact of market-size changes on rates, but it does preserve the hierarchy of rates across instruments.


Stocks and bonds have long duration, which leads to uncertainty about future prices should investors wish to liquidate, while the duration of money-market instruments is short and price variation is relatively small. Hence, the link between volume and liquidity may be very different for money-market securities compared to equities. In this paper, we empirically test the link between market size/volume and liquidity for money-market instruments. We determine if a decrease in the size of the market for Bankers Acceptances (BAs) from 1984 to 2000 led to an increase in the liquidity premium for BAs, which in turn changed the relative relation between BA rates and the rates on other money-market instruments.

The ideal experimental setting to test for a direct link between low market size/volume and a high liquidity premium is one in which we can compare the returns from pairs of comparable securities with different volume. This experimental setting is difficult, if not impossible, to create in equities because of the difficulty in creating pairs of comparable securities. Money markets provide a better environment for testing the volume-liquidity conditions, because money-market securities are comparable, sharing the common characteristics of short-term maturity, low default risk, and high marketability. These common characteristics, coupled with an exogenous decline in BAs, provide an ideal experimental setting to investigate the interaction of volume and liquidity in short-term securities.

We compare the rates (yields) on bankers' acceptances to the rates on certificates of deposits (CDs), financial commercial paper (CP), and eurodollar deposits (EDs). Although all four of the money-market instruments constitute short-term borrowing, we note that the production of BAs differs from the production of CP, EDs, and CDs. Bankers' acceptances are a transaction-specific debt that is incurred when firms import and export goods. Eurodollars and Negotiable CDs constitute short-term borrowing by banks to acquire funds for general use. Financial CP is borrowing by a bank holding company for general use. However, the four instruments are homogeneous assets for investors because each has short-term maturity, low default risk, and high marketability.

In a traditional framework, a decline in BAs would lead to an inward shift in the supply curve, and with a static demand curve the result is an increase in price and lower yield. However, if the demand curves for assets with close substitutes are relatively flat (nearly horizontal), we would expect that price increases for BAs due to the decline in volume to be mitigated as investors switch to other instruments.

Our comparison of spreads between BAs and other money-market instruments covers the period from 1984 to 2000 when the supply of BAs declined by over 85%. Most of the decline occurred during the years 1991 to 2000. The decline was a supply phenomenon due to changes in the use of BAs in international trade, not a response to investor demand. In fact, the volume in the short-term security market increased over this period, particularly in the CP and CD markets.

The dynamics of the market over this period also include a narrowing of differences between rates for all of the money-market instruments. We isolate these other changes in the money markets from the changes in BAs. …

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