Liquidity and Credit Risk

Posted: 27 Jul 2005

See all articles by Jan Ericsson

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Olivier Renault

University of Warwick Business School - Financial Econometrics Research Centre

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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.

Keywords: Corporate bonds, financial distress, renegotiation, liquidity risk

JEL Classification: G13

Suggested Citation

Ericsson, Jan and Renault, Olivier M., Liquidity and Credit Risk. Journal of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=760024

Jan Ericsson (Contact Author)

McGill University ( email )

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Swedish Institute for Financial Research (SIFR)

Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden

Olivier M. Renault

University of Warwick Business School - Financial Econometrics Research Centre ( email )

Coventry CV4 7AL
United Kingdom

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