Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle

Hui Chen (), Rui Cui, Zhiguo He () and Konstantin Milbradt

No 20638, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We develop a structural credit risk model to examine how the interactions of liquidity and default risk affect corporate bond pricing. By explicitly modeling debt rollover and by endogenizing the holding costs via collateralized financing, our model generates rich links between liquidity risk and default risk. The introduction of macroeconomic risks helps the model capture realistic time variation in default risk premia and the default-liquidity spiral over the business cycle. Across different credit ratings, our calibrated model can simultaneously match the average default probabilities, credit spreads, and bond liquidity measures including Bond-CDS spreads and bid-ask spreads in the data. Through a structural decomposition, we show that the interactions between liquidity and default risk account for 25∼40% of the observed credit spreads and up to 55% of the credit spread changes over the business cycle. As an application, we use this framework to quantitatively evaluate the effects of liquidity-provision policies for the corporate bond market.

JEL-codes: G00 G1 G12 G20 (search for similar items in EconPapers)
Date: 2014-10
New Economics Papers: this item is included in nep-rmg
Note: AP CF
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Citations: View citations in EconPapers (8)

Published as Hui Chen & Rui Cui & Zhiguo He & Konstantin Milbradt, 2018. "Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle," The Review of Financial Studies, vol 31(3), pages 852-897.

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Journal Article: Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle (2018)
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