This paper examines the price differences between very liquid on-the-run U.S. Treasury securities and less liquid off-the-run securities over the on/off cycle. Comparing pairs of securities in time-series regressions allows us to disregard any fixed cross-sectional differences between securities. Also, since the liquidity of Treasury notes varies predictably over time, we can distinguish between current and future liquidity. We compare a variety of (microstructure-based) direct measures of liquidity to compare their effects on prices. We show that the liquidity premium depends primarily on the amount of remaining future liquidity.

We examine a set of equity index-linked bonds that provide the same payoff as an investment in an equity index, but are relatively illiquid. We demonstrate that these securities sell at a discount relative to their underlying value and hence have higher expected returns. We show that this apparent mispricing can be attributed to the illiquidity of the bonds. Trading costs for equity-linked bonds, as measured by bid-ask spreads, are free of any asymmetric information or inventory holding cost component; hence the only illiquidity component left is clearing costs. This study shows that, even in the absence of asymmetric information and inventory holding costs, illiquidity depresses asset prices and therefore increases expected security returns. Using an ex ante measure of the expected return premium due to illiquidity, we link the time-series variation in the illiquidity premium to security-specific attributes related to their marketability. We show that liquidity risk has a systematic component, and relate this market-wide factor to a number of macroeconomic variables that have previously been shown to be related to illiquidity.