I exploit a Dutch reform in the regulatory discount curve that makes the liabilities of pension funds and insurance companies (P&Is) more sensitive to changes in 20-year interest rates but less so to longer maturity rates. Following the reform, P&Is reduced their longest maturity bond holdings but increased those with 20-year maturities, steepening the long end of the yield curve. Using the reform as a shock to identify price elasticities of demand at the sector level based on holdings across maturity buckets and time, I show that banks are more price elastic than other investors and absorb demand shocks.

Pension funds use interest rate swaps to hedge the interest rate risk arising from their liabilities. Analyzing regulatory data on Dutch pension funds, we show that pension funds with worse funding ratios, indicating greater fragility, use swaps more aggressively. These swap positions expose pension funds to the risk of margin calls, which can exceed 6% of their total assets, when interest rates rise. Pension funds respond to realized margin calls by selling safe government bonds with medium-term maturities. This procyclical selling behavior adversely affects the prices of the sold bonds and thereby exposes pension funds to market liquidity risk.

We solve a flexible model that captures transactions costs and infrequencies of trading opportunities for illiquid assets to better understand the shadow costs of illiquidity for different origins of asset illiquidity and heterogeneous investor types. We show that illiquidity that results in suboptimal asset allocation carries low shadow costs, whereas these costs are high when illiquidity restricts consumption. As a result, the shadow costs are high for short-term investors, investors who face substantial liquidity shocks, and investors who desire to allocate a large fraction of their wealth to illiquid assets.