Systematic Liquidity Risk in the Australian Bond Market

Abstract

This research examines recent developments in asset pricing theories and their ability to explain Australian bond market returns. This study develops a multifactor bond pricing model in an Australian setting. We examine the Lin et al. (2011) systematic liquidity factor to evaluate its power in explaining Australian bond returns. This study shows that the term, default and liquidity factors are important systematic risk factors in explaining the variation of returns of individual bonds and bond portfolios in Australia. The Australian bond pricing model developed in this study allows market participants to evaluate the risk factors that drive Australian bond portfolio returns regardless of their credit rating, liquidity, duration or industry sector concentration. In a simple case study, the Australian bond pricing model explains more than 82 percent of the variation of returns of Public Private Partnership (PPP) bond portfolios comprising of firms that are financially solvent.