Bond elasticity under liquidation risk

We derive a model for the valuation of government bonds subject to liquidation risk. We show that the value of a government bond depends on the term structures of the conditional probability of liquidation facing the portfolio manager, the bid-ask spread, and the riskless rate. We derive an expression for the elasticity of a government bond adjusted for the risk of liquidation with respect to shifts in the riskless term structure of interest rates. Failing to adjust elasticity for liquidation risk may be costly for bond portfolio managers utilizing active, rate-anticipation duration strategies based on Macaulay duration.