Debt Valuation and Marketability Risk

This paper studies the valuation of corporate debt contracts in an intertemporal setting under uncertainty taking into account the possibility that the bondholder will be unable to sell his asset. The model considers a coupon paying debt contract with default risk in a binomial setting. Randomly matched investors who place different values upon the firm in bankruptcy bargain for the price of the asset in a secondary market. With this framework we are able to isolate the influence of liquidity risk in the pricing of risky debt contracts. This influence is shown to be function of the heterogeneity of investors' valuations and the range of uncertainty concerning potential bankruptcy costs. In particular, even though mean bankruptcy costs may be relatively low, uncertainty about them can generate relatively large spreads. Furthermore this model is capable of generating a large variety of shapes for the term structure of yield spreads. Finally, the model captures the fact that early after the issue, a bond is relatively liquid and later becomes relatively illiquid depending on the underlying asset value.