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Endogenous Liquidity and Defaultable Bonds

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  • Zhiguo He
  • Konstantin Milbradt
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    Abstract

    This paper studies the interaction between fundamental and liquidity for defaultable corporate bonds that are traded in an over-the-counter secondary market with search frictions. Bargaining with dealers determines a bond's endogenous liquidity, which depends on both the firm fundamental and the time-to-maturity of the bond. Corporate default decisions interact with the endogenous secondary market liquidity via the rollover channel. A default-liquidity loop arises: Earlier endogenous default worsens a bond's secondary market liquidity, which amplifies equity holders' rollover losses, which in turn leads to earlier endogenous default. Besides characterizing in closed form the full inter-dependence between liquidity premium and default premium for credit spreads, we also study the optimal maturity implied by the model based on the tradeoff between liquidity provision and inefficient default.

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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18408.

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    Date of creation: Sep 2012
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    Handle: RePEc:nbr:nberwo:18408

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