Realized Volatility, Liquidity, and Corporate Yield Spreads
University of Notre Dame - Department of Finance
December 7, 2009
This study revisits the relative role of credit risk and illiquidity as determinants of corporate bond prices. Using TRACE transaction data from January 2003 to December 2008, I find that high-frequency firm equity volatility measures explain 40% of the variation of corporate yield spreads and as much as 52% of the variation in a multivariate context. In contrast, trading-based illiquidity measures such as the percentage of zero trading days, the friction measure used by Chen, Lesmond, and Wei (2007), and a new measure derived in this paper explain approximately an incremental 1% of the cross-sectional variation of yield spreads. Unlike other friction models, the proposed model includes firm-specific factors in the return generating process and relaxes the assumption of constant liquidity. As a result, liquidity cost estimates are lower and uncorrelated with corporate yield spreads. Overall, my findings suggest that credit risk is the main determinant of corporate yield spreads and that certain trading-based illiquidity measures actually capture credit risk.
Number of Pages in PDF File: 58
Keywords: liquidity, credit risk, realized volatility, stochastic friction, TRACE
JEL Classification: C11, G12working papers series
Date posted: March 17, 2010
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