Liquidity and Credit Risk

by Jan Ericsson of McGill University, and
Olivier Renault of the London School of Economics

October 2006

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.

JEL Classification: G13.

Keywords: Liquidity risk, workouts, default risk, corporate bonds.

Published in: Journal of Finance, Vol. 61, No. 5, (October 2006), pp. 2219-2250.

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Related reading: "Liquidity and Credit Risk" by Cherubini & Lunga