Liquidity and credit risk

Ericsson, Jan and Renault, Olivier (2000) Liquidity and credit risk. Financial Markets Group Discussion Papers (362). Financial Markets Group, The London School of Economics and Political Science, London, UK.

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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.

Item Type:	Monograph (Discussion Paper)
Official URL:	https://www.fmg.ac.uk/
Additional Information:	© 2000 The Authors
Divisions:	Financial Markets Group
Subjects:	H Social Sciences > HC Economic History and Conditions H Social Sciences > HG Finance
JEL classification:	G - Financial Economics > G1 - General Financial Markets > G10 - General G - Financial Economics > G2 - Financial Institutions and Services > G20 - General
Date Deposited:	04 Jul 2023 10:00
Last Modified:	16 Sep 2023 00:02
URI:	http://eprints.lse.ac.uk/id/eprint/119096

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