Can liquidity risk be subsumed in credit risk? A case study from Brady bond prices
by Henri Pagès of the Bank for International Settlement
Abstract: The paper applies a reduced-form model to uncover from secondary market's Brady bond prices, together with Libor interest rates, how the risk of sovereign default is perceived to depend upon time. The methodology is implemented on a particular issue, a discount bond issued by Brazil and maturing in April 2024. It is shown that subsuming liquidity risk in default risk may result in a misspecified model that, while generating the desired negative correlation between credit spreads and default-free interest rates, also generates negative probabilities of default at long horizons.