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Defaultable bond liquidity spread estimation: an option-based approach

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  • Pietro Rossi
  • Paolo Spezzati
  • Riccardo Tedeschi

Abstract

This paper extends an option-theoretic approach to estimate liquidity spreads for corporate bonds. Inspired by Longstaff's equity market framework and subsequent work by Koziol and Sauerbier on risk-free zero-coupon bonds, the model views liquidity as a look-back option. The model accounts for the interplay of risk-free rate volatility and credit risk. A numerical analysis highlights the impact of these factors on the liquidity spread, particularly for bonds with different maturities and credit ratings. The methodology is applied to estimate the liquidity spread for unquoted bonds, with a specific case study on the Republic of Italy's debt, leveraging market data to calibrate model parameters and classify liquid versus illiquid emissions. This approach provides a robust tool for pricing illiquid bonds, emphasizing the importance of marketability in debt security valuation.

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  • Pietro Rossi & Paolo Spezzati & Riccardo Tedeschi, 2025. "Defaultable bond liquidity spread estimation: an option-based approach," Papers 2501.11427, arXiv.org.
    • Handle: RePEc:arx:papers:2501.11427
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    References listed on IDEAS

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    1. Lars E.O. Svensson, 1994. "Estimating and Interpreting Forward Interest Rates: Sweden 1992 - 1994," NBER Working Papers 4871, National Bureau of Economic Research, Inc.
    2. Svensson, Lars E O, 1994. "Estimating and Interpreting Forward Interest Rates: Sweden 1992-4," CEPR Discussion Papers 1051, C.E.P.R. Discussion Papers.
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