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For the valuation of a bond, is the bid ask spread somehow reflected in the yield curve? Considering zero coupon bond, one would expect to have an bid price and ask price and therefore if I am calculating the zero rate, I will have two value and this results in two different zero curves. How is it about yield curve? How would the liquidity affect the yield curve?

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For a bond, or any security for that matter, the price you pay (or receive)is the price you get(or receive). The spread is only good for knowing where you can buy (or sell) at any given moment in time. Your "price" is where you execute your order. There is (almost) never a singular price that you can consider to be "the" price. It depends if you are buying or selling. I'm sure this sounds confusing...welcome to reality

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  • $\begingroup$ Thanks for your answer, I understand the price modeling involves a lot of reality effect. However, by ignoring those effect like non linear trading cost, I want to model the effect of trading cost to the Bond price, which is involved with the yield curve. I am trying to find a way how to model it in the presence of transaction cost and illiquidity $\endgroup$ – quallenjäger May 7 '17 at 0:57
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    $\begingroup$ There is a bid price and an ask price, so there is a bid yield and an ask yield. The yield curve is usually constructed by taking the midpoint of these yields. $\endgroup$ – dm63 May 7 '17 at 12:09

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