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Liquidity and Credit Risk

  • Olivier Renault
  • Jan Ericsson

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 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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File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmg_pdfs/dp362.pdf
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Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp362.

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Date of creation: Nov 2000
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Handle: RePEc:fmg:fmgdps:dp362
Contact details of provider: Web page: http://www.lse.ac.uk/fmg/

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