Liquidity and Credit Risk

Olivier Renault and Jan Ericsson

FMG Discussion Papers from Financial Markets Group

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 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.

Date: Written
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Related works:
Working Paper: Liquidity and Credit Risk (2001)
Journal Article: Liquidity and Credit Risk (2006)
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