Abstract

The present study seeks to contribute to the explanation of the non-default component within corporate-U.S. Treasury yield spreads. This is done by extending the model by Krishnamurthy and Vissing-Jorgensen (2012), assuming that investors value not only U.S. Treasuries' liquidity but instead value liquidity independently from the underlying asset. For that purpose I modify a standard asset pricing model by allowing certain groups of assets to directly contribute to investor's utility. Empirical tests of the model's implications confirm this view and show that changes in the holdings of most liquid assets cause a stronger impact on corporate-Treasury yield spreads compared to changes in the holdings of least liquid assets. Finding this systematic pattern, points to the existence of a demand function for liquidity. Further, I provide evidence that changes in the holdings of liquid assets are priced separately from commonly used controls for credit default risk, as well as from controls measuring an asset's market liquidity.

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