Galo Nuno (Banco de España) - Debt-Maturity Management with Liquidity Costs

Co-authors: Saki Bigio (UCLA) and Juan Passadore (EIEF)

We document the presence of significant liquidity costs in Spanish sovereign debt auctions: the larger the auctioned amounts, the lower the issuance price relative to secondary market prices. Motivated by this evidence, we characterize the optimal debt-maturity management problem of a government that issues finite-maturity bonds of various maturities, in the presence of such liquidity costs. Liquidity costs induce a value gap: a difference between the market price of a bond and the valuation of the bond using the government’s discount factor. Optimal issuances are spread out across maturities and are dictated by the value gap scaled by a liquidity coefficient. This characterization allows us to quantify how the government’s relative impatience, yield-curve riding, and expenditure smoothing shape the optimal debt-maturity distribution. The model can rationalize actual debt-management practices.

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