Limits to arbitrage and the term structure of bond illiquidity premiums

Theoretical models suggest that the relation of speculators' capital and market liquidity is highly nonlinear. Changes in capital only marginally affect liquidity when capital is available abundantly, but have a large effect when capital is scarce. In this paper, we confirm this relation within a regime-switching model using three broad measures of German bond market liquidity. We then analyze how the term structure of illiquidity premiums of German agency bonds is related to intermediaries' capital and foreign flows. Illiquidity premiums are related to both variables only in the stress regime. The effect of intermediaries' capital is most strongly pronounced at the short end of the term structure. In contrast, flows into and out of the illiquid bond market segment constitute a level effect as they are related to illiquidity premiums of all maturities.