Credit spreads, endogenous bankruptcy and liquidity risk

Jianping Fu, Xingchun Wang () and Yongjin Wang

Computational Management Science, 2012, vol. 9, issue 4, 515-530

Abstract: In this paper, we consider a bond valuation model with both credit risk and liquidity risk to show that credit spreads are not negligible for short maturities. We adopt the structural approach to model credit risk, where the default triggering barrier is determined endogenously by maximizing equity value. As for liquidity risk, we assume that bondholders may encounter liquidity shocks during the lifetime of corporate bonds, and have to sell the bond immediately at the price, which is assumed to be a fraction of the price in a perfectly liquid market. Under this framework, we derive explicit expressions for corporate bond, firm value and bankruptcy trigger. Finally, numerical illustrations are presented. Copyright Springer-Verlag 2012

Keywords: Liquidity risk; Credit risk; Credit spreads; Endogenous bankruptcy; 60H30; 91G40; 91G50 (search for similar items in EconPapers)
Date: 2012
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DOI: 10.1007/s10287-012-0153-3

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