Calculating the Liquidity Premium in the Nominal Treasury Market
There are multiple ways to calculate the liquidity premium in the nominal Treasury market. This note describes some of the issues involved in the method the Board of Governors of the Federal Reserve System uses to calculate the estimates of the liquidity premium, which we use.
Four of the series used to calculate the liquidity premium are:
CM10: The ten-year constant maturity yield calculated by the Treasury Department on an investment basis using the daily quotes provided to the New York Fed by primary dealers on the most actively traded (i.e., on-the-run) securities.
ONTHERUN10: The yield of the current 10-year on-the-run security as provided by the New York Fed (again, who get their data from Treasury dealers).
OFFRUNY1000: The 10-year constant maturity zero-coupon yield from our Fisher-Zervos off-the-run yield curve model, using the same New York Fed quotes.
SYN_10ON: The off-the-run equivalent yield of the current ten-year on-the-run security. This bond is “synthesized” by summing all future payments of the on-the-run security discounted using the Fisher-Zervos zero-coupon (off-the-run) yield curve.
One can crudely measure the liquidity premium using the spread of ONTHERUN10 and SYN_10ON, but because the on-the-run premium declines as the security ages (i.e., approaches off-the-run status) this measure should be adjusted for this trend effect. We perform this adjustment usinghistorical trends of on-the-run securities.
Another crude method is to take the spread of ONTHERUN10 and the first off-the-run security. The problem with this method is that the two securities have different maturities, which, depending on the slope of the yield curve, can have a sizeable effect (and the premium will not always be positive).