Note that shifts in market supply and demand affect the paper-bill spread as long as paper and bills are imperfect substitutes i.e., h , `. When the substitutability rises— due to
increased liquidity of commercial paper—the spread becomes less sensitive to exogenous changes in supply and demand.
11
If this explanation is correct, we should observe that the reduced form parameters in equation 5 are systematically linked to paper market
liquidity.
12
Equation 6 reveals an additional way to test the liquidity explanation for the breakdown in the spread’s predictive performance. Note that the error term variance falls
when the substitutability between paper and bills rises. If the error term in equation 5 displays heteroskedasticity induced by changes in the liquidity of paper, there is additional
evidence that the decline in the spread’s predictive power resulted from a reduction in its ability to reflect supply and demand shocks.
III. Data Preliminaries
Our objective was to estimate equation 5. To do so, we followed previous work when measuring the model’s variables.
13
The paper-bill spread SPREAD is the difference between the 6-month commercial paper and Treasury bill rates. The spread is illustrated
in Figure 1 along with NBER-dated recessions shaded regions. To gauge the stance of monetary policy, we used the spread between the 10-year Treasury bond yield and federal
funds rate SLOPE.
14
The spread between BAA and AAA corporate bond rates QUAL was used to measure default risk. To measure inventories, we used the log of real
manufacturing inventories INV. Interest rate uncertainty was quantified by fitting a GARCH 1, 1 model to daily 3-month Treasury bill yields and averaging the conditional
standard deviations over the month. Because empirical relationships between liquidity premia and uncertainty are often concave, we used the log value of this series UNCERT.
To measure the relative liquidity of commercial paper, we started by taking the ratio of the quantity of bills outstanding to paper outstanding. The log of this ratio, Q
B
Q
P
, is illustrated in Figure 2. As the volume of paper outstanding rises, the number of potential
investors and market makers willing to take the other side of trades also rises. This reduces search costs and raises the liquidity of commercial paper.
15
To avoid associating tempo- rary movements in the volume ratio with changes in liquidity, we used two different
measures of its trend value to measure the relative liquidity of commercial paper. The first is a polynomial time trend fit to the volume ratio, Q
B
Q
P T
, shown in Figure 2. We also measured the trend by taking a moving average of the volume ratio over the previous 12
months, exclusive of the current month.
11
In the limit, when paper and bills are perfect substitutes, the reduced-form parameters in equation 5 equal zero, and shifts in supply and demand have no impact on the spread. In this case, a yield increase in one market
stimulates arbitrage across the markets which continues until the initial shock is absorbed by equal changes in both rates.
12
Note that the second explanation requires that the substitutability between bills and paper has not declined.
13
Data sources are given in Appendix 2.
14
This approach is used by Blinder and Bernanke 1992, Bernanke 1990, and Kashyap, Wilcox and Stein 1993.
15
A common way to measure liquidity of an asset is to use its bid-ask spread. Unfortunately, such spreads are not publicly available for commercial paper. Nevertheless, the trend of the ratio illustrated in Figure 1
generally reflects the behavior of bid-ask spreads in these markets in recent years as noted by some observers. For example, Stigum 1990 pointed out that dealer bid-ask spreads fell from 13 to 5 basis points during the
1980s.
366 J. P. Ferderer et al.
The trend volume ratios indicate that the liquidity of the paper market was rising up to 1989. Then, beginning in 1990, the volume ratio began to increase.
16
Does this indicate that paper market liquidity was falling during the 1990s? Perhaps. However, the costs
associated with providing liquidity to the market are largely fixed and sunk. Thus, we should not expect that the number of dealers providing liquidity services to fall dramat-
ically when the volume of paper in the market stops growing for a few years.
Table 1 contains stationary tests for the series. For the interest rate spread and uncertainty series, the null hypothesis is that each variable has a unit root and the
alternative hypothesis is that the series is stationary around a constant mean. For inven- tories and the bill-paper volume ratio, we tested the unit root null against an alternative
which specified that the series is stationary around a linear trend. The results indicate that the unit root null can be rejected at conventional significance levels for each of the spread
variables and interest rate uncertainty. In contrast, the inventories series was stationary only after it had been first-differenced. Moreover, both the augmented Dickey-Fuller
statistic and the exclusion test suggest that the bill-paper volume ratio is stationary around a linear trend.
16
According to Friedman and Kuttner 1994, growth of the paper market slowed in the 1990s as the corporate leverage movement of the 1980s came to an end. The 1990–1991 recession also played a role. In
contrast, net Treasury bill issuance expanded greatly during this period and reflected a combination of fiscal, debt-management and exchange-rate policies.
Figure 1. Paper-bill spread.
Increasing Liquidity of the Paper-Bill Spread 367
IV. Empirical Results
