Endogenous Liquidity and Defaultable Bonds

Zhiguo He () and Konstantin Milbradt

No 18408, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper studies the interaction between fundamental and liquidity for defaultable corporate bonds that are traded in an over-the-counter secondary market with search frictions. Bargaining with dealers determines a bond's endogenous liquidity, which depends on both the firm fundamental and the time-to-maturity of the bond. Corporate default decisions interact with the endogenous secondary market liquidity via the rollover channel. A default-liquidity loop arises: Earlier endogenous default worsens a bond's secondary market liquidity, which amplifies equity holders' rollover losses, which in turn leads to earlier endogenous default. Besides characterizing in closed form the full inter-dependence between liquidity premium and default premium for credit spreads, we also study the optimal maturity implied by the model based on the tradeoff between liquidity provision and inefficient default.

JEL-codes: E44 G01 G12 (search for similar items in EconPapers)
Date: 2012-09
New Economics Papers: this item is included in nep-dge and nep-mac
Note: AP CF EFG
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Citations: View citations in EconPapers (7)

Published as Zhiguo He & Konstantin Milbradt, 2014. "Endogenous Liquidity and Defaultable Bonds," Econometrica, Econometric Society, vol. 82(4), pages 1443-1508, July.

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Journal Article: Endogenous Liquidity and Defaultable Bonds (2014)
Working Paper: Endogenous liquidity and defaultable bonds (2012)
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