Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle / Hui Chen, Rui Cui, Zhiguo He, Konstantin Milbradt.

Format:

Book

Author/Creator:

Chen, Hui.

Contributor:

National Bureau of Economic Research.

Cui, Rui.

He, Zhiguo.

Milbradt, Konstantin.

Series:

Working Paper Series (National Bureau of Economic Research) no. w20638.

NBER working paper series no. w20638

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2014.

Summary:

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.

Notes:

Print version record

October 2014.