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Liquidity and Credit Risk

Authors

  • JAN ERICSSON,

  • OLIVIER RENAULT

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    • Ericsson is from McGill University and the Swedish Institute for Financial Research; Renault is from the Fixed Income Quantitative Research group of Citigroup Global Markets Ltd. and the Financial Econometrics Research Centre at the University of Warwick.

ABSTRACT

We develop a structural bond valuation model to simultaneously capture liquidity and credit risk. Our model implies that renegotiation in financial distress is influenced by the illiquidity of the market for distressed debt. As default becomes more likely, the components of bond yield spreads attributable to illiquidity increase. When we consider finite maturity debt, we find decreasing and convex term structures of liquidity spreads. Using bond price data spanning 15 years, we find evidence of a positive correlation between the illiquidity and default components of yield spreads as well as support for downward-sloping term structures of liquidity spreads.

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