Quantifying Liquidity and Default Risks of Corporate Bonds Over the Business Cycle

61 Pages Posted: 3 Nov 2014 Last revised: 2 Mar 2018

See all articles by Hui Chen

Hui Chen

Massachusetts Institute of Technology; National Bureau of Economic Research (NBER)

Rui Cui

University of Chicago - Finance

Zhiguo He

University of Chicago - Finance

Konstantin Milbradt

Northwestern University - Kellogg School of Management - Department of Finance

Date Written: October 2014

Abstract

We develop a structural credit risk model to examine how the interactions of liquidity and default risk affect corporate bond pricing. By explicitly modeling debt rollover and by endogenizing the holding costs via collateralized financing, our model generates rich links between liquidity risk and default risk. The introduction of macroeconomic risks helps the model capture realistic time variation in default risk premia and the default-liquidity spiral over the business cycle. Across different credit ratings, our calibrated model can simultaneously match the average default probabilities, credit spreads, and bond liquidity measures including Bond-CDS spreads and bid-ask spreads in the data. Through a structural decomposition, we show that the interactions between liquidity and default risk account for 25∼40% of the observed credit spreads and up to 55% of the credit spread changes over the business cycle. As an application, we use this framework to quantitatively evaluate the effects of liquidity-provision policies for the corporate bond market.

Suggested Citation

Chen, Hui and Cui, Rui and He, Zhiguo and Milbradt, Konstantin, Quantifying Liquidity and Default Risks of Corporate Bonds Over the Business Cycle (October 2014). NBER Working Paper No. w20638, Available at SSRN: https://ssrn.com/abstract=2518728

Hui Chen (Contact Author)

Massachusetts Institute of Technology ( email )

50 Memorial Drive
Cambridge, MA 02142
United States
617-324-3896 (Phone)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Rui Cui

University of Chicago - Finance ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Zhiguo He

University of Chicago - Finance ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

HOME PAGE: http://www.zhiguohe.com

Konstantin Milbradt

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

Evanston, IL 60208
United States

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