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Liquidity and Credit Risk

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Author Info

  • Jan ERICSSON

    (McGill University)

  • Olivier RENAULT

    (London School of Economics)

Abstract

We develop a simple binomial model of liquidity and credit risk in which a bondholder has the option to time the sale of his security, given a distribution of potential buyers, bids and liquidity shocks. We examine first the case without default and find that our model predicts decreasing term structures of liquidity premia, consistent with empirical evidence. In the default risky case, we find that liquidity spreads are positively related to credit risk. Using a sample of US corporate bonds, we find support for the time to maturity effect and the positive correlation between credit and liquidity spreads.

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Bibliographic Info

Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp42.

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Date of creation: Aug 2001
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Handle: RePEc:fam:rpseri:rp42

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