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Liquidity Risk in the Corporate Bond Markets

by George Chacko of Harvard University & IFL

April 2006

Abstract: A great deal of work has focused on market microstructure, but relatively little work has been devoted to the study of risk associated with liquidity. The work that has been done has almost exclusively focused on US equities - primarily because that market is fairly liquid and therefore data is plentiful. However, because that market is liquid, the empirical results been mixed - the effects of illiquidity are likely small in a market with a large amount of trading (and therefore transactions data). For our work, we turn to the US corporate bond market. Because the corporate bond market is several orders of magnitude more illiquid than the equity market, this seems a much more appropriate setting to study the effects of illiquidity. To get around the problem of a lack of trading and transactions data, we construct a new measure of liquidity which does not require trading. Using this measure, we show that not only is liquidity risk priced, but that the effects of liquidity risk are quite pervasive and need to be controlled for carefully when doing virtually any analysis of security returns.

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