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Credit spreads, endogenous bankruptcy and liquidity risk

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  • Jianping Fu
  • Xingchun Wang
  • Yongjin Wang

Abstract

In this paper, we consider a bond valuation model with both credit risk and liquidity risk to show that credit spreads are not negligible for short maturities. We adopt the structural approach to model credit risk, where the default triggering barrier is determined endogenously by maximizing equity value. As for liquidity risk, we assume that bondholders may encounter liquidity shocks during the lifetime of corporate bonds, and have to sell the bond immediately at the price, which is assumed to be a fraction of the price in a perfectly liquid market. Under this framework, we derive explicit expressions for corporate bond, firm value and bankruptcy trigger. Finally, numerical illustrations are presented. Copyright Springer-Verlag 2012

Suggested Citation

  • Jianping Fu & Xingchun Wang & Yongjin Wang, 2012. "Credit spreads, endogenous bankruptcy and liquidity risk," Computational Management Science, Springer, vol. 9(4), pages 515-530, November.
    • Handle: RePEc:spr:comgts:v:9:y:2012:i:4:p:515-530
    DOI: 10.1007/s10287-012-0153-3
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    Cited by:

    1. Xingchun Wang, 2021. "Pricing vulnerable options with jump risk and liquidity risk," Review of Derivatives Research, Springer, vol. 24(3), pages 243-260, October.
    2. Wang, Xingchun, 2022. "Pricing vulnerable options with stochastic liquidity risk," The North American Journal of Economics and Finance, Elsevier, vol. 60(C).

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