Liquidity and credit risk

Jan Ericsson and Olivier Renault

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

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 and MENDELSON (1990). Then, we study the default risky case and show that credit risk influences liquidity spreads in a non-trivial way. We find that liquidity spreads are an increasing function of the volatility of the firm's 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 credit and liquidity risks.

Keywords: credit risk; liquidity; structural models (search for similar items in EconPapers)
JEL-codes: G10 G20 (search for similar items in EconPapers)
Pages: 31 pages
Date: 2000-10-01
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:119096

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