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Liquidity and Credit Risk

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Author Info
Jan ERICSSON (McGill University)
Olivier RENAULT (London School of Economics)

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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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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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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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  1. Andreas Stephan & Oleksandr Talavera & Andriy Tsapin, 2008. "Corporate Debt Maturity Choice in Transition Financial Markets," Discussion Papers of DIW Berlin 784, DIW Berlin, German Institute for Economic Research. [Downloadable!]
    Other versions:
  2. Hayette Gatfaoui, 2003. "How Does Systematic Risk Impact US Credit Spreads? A Copula Study," Risk and Insurance 0308002, EconWPA. [Downloadable!]
  3. Gady Jacoby & Chuan Liao & Jonathan A. Batten, 2007. "A Pure Test for the Elasticity of Yield Spreads," The Institute for International Integration Studies Discussion Paper Series iiisdp195, IIIS. [Downloadable!]
  4. Juan Ignacio Pena & Santiago Forte, 2006. "CREDIT SPREADS: THEORY AND EVIDENCE ABOUT THE INFORMATION CONTENT OF STOCKS, BONDS AND CDSs," Business Economics Working Papers wb063310, Universidad Carlos III, Departamento de Economía de la Empresa. [Downloadable!]
  5. Miguel A. Martínez & Belén Nieto & Gonzalo Rubio & Mikel Tapia, 2002. "Asset Pricing And Systematic Liquidity Risk: An Empirical Investigation Of The Spanish Stock Market," Business Economics Working Papers wb026022, Universidad Carlos III, Departamento de Economía de la Empresa. [Downloadable!]
  6. Reneby, Joel & Ericsson, Jan, 2001. "The Valuation of Corporate Liabilities: Theory and Tests," Working Paper Series in Economics and Finance 445, Stockholm School of Economics, revised 19 Dec 2002. [Downloadable!]
  7. J.L. Prigent & O. Renault & O.Scaillet, 2000. "An Empirical Estimation in Credit Spread Indices," THEMA Working Papers 2000-51, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise. [Downloadable!]
  8. Gann, Philipp & Laut, Amelie, 2008. "Einflussfaktoren auf den Credit Spread von Unternehmensanleihen," Discussion Papers in Business Administration 4231, University of Munich, Munich School of Management. [Downloadable!]
  9. Ericsson, Jan & Reneby, Joel, 2003. "Valuing Corporate Liabilities," SIFR Research Report Series 15, Institute for Financial Research. [Downloadable!]
  10. Décamps, Jean-Paul & Villeneuve, Stéphane, 2008. "On the Modeling of Debt Maturity and Endogenous Default: A Caveat," IDEI Working Papers 528, Institut d'Économie Industrielle (IDEI), Toulouse.
  11. Favero, Carlo A & Pagano, Marco & von Thadden, Ernst-Ludwig, 2008. "How Does Liquidity Affect Government Bond Yields?," CEPR Discussion Papers 6649, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  12. Song Han & Hao Zhou, 2008. "Effects of liquidity on the nondefault component of corporate yield spreads: evidence from intraday transactions data," Finance and Economics Discussion Series 2008-40, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  13. Gonzalo Rubio & Miguel Angel A. Martinez & Belén Nieto, 2003. "Asset pricing and systematic liquidity risk," DFAEII Working Papers 200205, University of the Basque Country - Department of Foundations of Economic Analysis II. [Downloadable!]
  14. Hayette Gatfaoui, 2003. "Risque de Défaut et Risque de Liquidité : Une Etude de Deux Composantes du Spread de Crédit," Risk and Insurance 0308005, EconWPA. [Downloadable!]
  15. Hayette Gatfaoui, 2004. "Idiosyncratic Risk, Systematic Risk and Stochastic Volatility: An Implementation of Merton's Credit Risk Valuation," Research Paper Series 123, Quantitative Finance Research Centre, University of Technology, Sydney.
  16. Alessandro Beber & Michael W. Brandt & Kenneth A. Kavajecz, 2006. "Flight-to-Quality or Flight-to-Liquidity? Evidence From the Euro-Area Bond Market," NBER Working Papers 12376, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  17. Marco Realdon, . "Corporate Bond Valuation with Both Expected and Unexpected Default," Discussion Papers 03/21, Department of Economics, University of York. [Downloadable!]
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