Liquidity and Credit Risk
AbstractWe 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 as a benchmark the case without default and find that our model predicts a decreasing term structure of liquidity premia, in accordance with the empirical findings of Amihud & Mendelson (1991). Then, we study the default risky case and show that credit risk influences liquidity spread in a non-trivial way. We find that liquidity spreads are an increasing function of the volatility of the firms assets and leverage - the key determinants of credit risk. Furthermore we show that bondholders are more likely to sell their holdings voluntarily when bond maturity is distant and when default becomes more probable. Finally, in a sample of US corporate bonds, we find support for the time to maturity effect and the positive correlation between crudity and liquidity risks.
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Bibliographic InfoPaper provided by Financial Markets Group in its series FMG Discussion Papers with number dp362.
Date of creation: Nov 2000
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Web page: http://www.lse.ac.uk/fmg/
Other versions of this item:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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