Endogenous Liquidity and Defaultable Bonds

62 Pages Posted: 21 Aug 2012 Last revised: 10 Apr 2013

Multiple version iconThere are 2 versions of this paper

Date Written: July 8, 2012

Abstract

This paper studies the interaction between fundamental and liquidity for defaultable corporate bonds that are traded in an over-the-counter secondary market with search frictions. Bargaining with dealers determines a bond’s endogenous liquidity, which depends on both the firm fundamental and the time-to-maturity of the bond. Corporate default decisions interact with the endogenous secondary market liquidity via the rollover channel. A default-liquidity loop arises: Earlier endogenous default worsens a bond’s secondary market liquidity, which amplifies equity holders’ rollover losses, which in turn leads to earlier endogenous default. Besides characterizing in closed form the full inter-dependence between liquidity premium and default premium for credit spreads, we also study the optimal maturity implied by the model based on the tradeoff between liquidity provision and inefficient default.

Keywords: Positive Feedback, Fundamental and Liquidity, Over-The-Counter Market, Secondary Bond Market, Structural Models for Credit Risk, Transaction Cost for Corporate Bonds, Bid-Ask Spread

Suggested Citation

He, Zhiguo and Milbradt, Konstantin, Endogenous Liquidity and Defaultable Bonds (July 8, 2012). Chicago Booth Research Paper No. 12-32; Fama-Miller Working Paper. Available at SSRN: https://ssrn.com/abstract=2133446 or http://dx.doi.org/10.2139/ssrn.2133446

Zhiguo He (Contact Author)

University of Chicago - Booth School of Business, and NBER ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

HOME PAGE: http://faculty.chicagobooth.edu/zhiguo.he/pubs.html

Konstantin Milbradt

Northwestern University - Kellogg School of Management - Department of Finance ( email )

Evanston, IL 60208
United States

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