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Liquidity and credit risk

Author

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  • Ericsson, Jan
  • Renault, Olivier

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.

Suggested Citation

  • Ericsson, Jan & Renault, Olivier, 2000. "Liquidity and credit risk," LSE Research Online Documents on Economics 119096, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:119096
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    File URL: http://eprints.lse.ac.uk/119096/
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    More about this item

    Keywords

    credit risk; liquidity; structural models;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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