Increasing Liquidity and the Declining Informational Content of the Paper-Bill
Spread
J. Peter Ferderer, Stephen C. Vogt and Ravi Chahil
The paper constructs a theoretical model to show that the reduced-form relationship between the paper-bill spread and its determinants is sensitive to the substitutability
between paper and bills in investors’ portfolios. Using the trend ratio of bill to paper volume outstanding as a proxy for relative liquidity of commercial paper, we provide
evidence that the ability of the spread to embody important information fell as liquidity of the paper market increased during the 1980s.
© 1998 Elsevier Science Inc. Keywords: Liquidity; Business cycles
JEL classification: E32, E44
I. Introduction
Considerable attention has been devoted to analyzing the business cycle behavior of the spread between interest rates on commercial paper and Treasury bills. Early research in
this area documented and attempted to explain the paper-bill spread’s predictive power for business cycle fluctuations.
1
The view that has emerged is that the spread rises prior to and during economic contractions because it embodies information about: 1 the stance of
monetary policy; 2 the likelihood of default, and 3 cash flow needs linked to rising inventories.
More recent research has attempted to explain why the predictive power of the spread declined during the 1980s. One explanation suggests that, although the spread may reflect
important information about monetary policy or default risk associated with financial
Department of Economics, Macalester College, St. Paul, Minnesota; Department of Finance, DePaul University, Chicago, Illinois; Department of Economics, Clark University, Worcester, Massachusetts.
Address correspondence to: Dr. J. P. Ferderer, Department of Economics, Macalester College, 1600 Grand Avenue, St. Paul, MN 55105.
1
Relevant papers include Cook 1981, Rowe 1986, Stock and Watson 1989, Bernanke 1990, Friedman and Kuttner 1992, 1993, Kashyap et al. 1993, Bernanke and Blinder 1993.
Journal of Economics and Business 1998; 50:361–377 0148-6195 98 19.00
© 1998 Elsevier Science Inc., New York, New York PII S0148-61959800009-5
crises, these forces have recently played a diminished role in the business cycle [see Friedman and Kuttner 1994 and Emery 1996]. Also, it has been argued that changes
in the supply of commercial paper and Treasury bills, unrelated to business cycle conditions, have played a more dominant role in driving the spread.
An alternative explanation for the decline in the spread’s predictive power has its origins in the dramatic rise in liquidity of the paper market over the past two decades. As
Stigum 1990 has observed:
A commercial paper trader’s primary responsibility is to assist issuers, but he also has a second responsibility, to provide liquidity to investors. More than any other aspect of the commercial paper
market, it is the secondary market that has, in recent years, been developed. [Stigum 1990, p. 1051]
As the liquidity of commercial paper rises, it becomes a closer substitute to Treasury bills in investors’ portfolios. As a result, shocks to either the paper or bill market cause rates
in both markets to change proportionately. Thus, the spread is less sensitive to changes in market conditions linked to the business cycle.
Although this explanation has been discussed in the literature, it has not been formally analyzed.
2
The objective of this paper is to fill this void in the literature. We do so by constructing a theoretical model which shows precisely how the relationship between the
spread and its determinants is conditional on the substitutability between paper and bills in investors’ portfolios. Our second contribution is empirical. Using two different variants
of the trend ratio of bill to paper volumes outstanding as proxies for the relative liquidity of commercial paper, we show that the coefficients linking the spread to its determinants
fall as the liquidity of commercial paper rises. Moreover, we show that the paper-bill spread contains a liquidity premium which became less sensitive to interest rate uncer-
tainty during the 1980s.
The paper is outlined as follows. The theoretical model and a discussion of previous work are presented in Section II. Data and measurement issues are discussed in Section
III. The results are presented in Section IV, and Section V concludes the paper.
II. Conceptual Issues
