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Liquidity and Credit Risk

Author

Listed:
  • 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.

Suggested Citation

  • Jan ERICSSON & Olivier RENAULT, 2001. "Liquidity and Credit Risk," FAME Research Paper Series rp42, International Center for Financial Asset Management and Engineering.
  • Handle: RePEc:fam:rpseri:rp42
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    JEL classification:

    • 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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