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Joint estimation of liquidity and credit risk premia in bond prices with an application

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  • Jens H. E. Christensen
  • Daan Steenkamp

Abstract

This paper introduces a novel arbitrage-free dynamic term structure model that jointly accounts for liquidity and credit risk premia in panels of bond prices. While liquidity risk is bond-specific, credit risk is common across bonds and follows a square-root process to ensure nonnegativity and econometric identification. A simulation study confirms the separate identification of liquidity and credit risk. We apply the model to South African government bond prices and document the existence of large and weakly correlated liquidity and credit risk premia. This underscores that liquidity and credit stresses are distinct risks to bond investors.

Suggested Citation

  • Jens H. E. Christensen & Daan Steenkamp, 2025. "Joint estimation of liquidity and credit risk premia in bond prices with an application," Working Papers 11074, South African Reserve Bank.
    • Handle: RePEc:rbz:wpaper:11074
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    References listed on IDEAS

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    1. Scott Joslin & Kenneth J. Singleton & Haoxiang Zhu, 2011. "A New Perspective on Gaussian Dynamic Term Structure Models," The Review of Financial Studies, Society for Financial Studies, vol. 24(3), pages 926-970.
    2. John C. Cox & Jonathan E. Ingersoll Jr. & Stephen A. Ross, 2005. "A Theory Of The Term Structure Of Interest Rates," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 5, pages 129-164, World Scientific Publishing Co. Pte. Ltd..
    3. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, February.
    4. Joost Driessen, 2005. "Is Default Event Risk Priced in Corporate Bonds?," The Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 165-195.
    5. Beauregard, Remy & Christensen, Jens H.E. & Fischer, Eric & Zhu, Simon, 2024. "Inflation expectations and risk premia in emerging bond markets: Evidence from Mexico," Journal of International Economics, Elsevier, vol. 151(C).
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