Abstract
This paper investigates the effect of liquidity on bond risk premium in a model of endogenous debt maturity, in which a firm balances between rollover risk induced by short-term debt and liquidity risk of long-term bonds. Our model generates implications consistent with existing empirical findings. First, bond illiquidity can increase bond risk premium indirectly by increasing the amount of short-term debt and rollover risk, leading to comovement between liquidity risk premium and default risk premium. Second, bond illiquidity has a larger effect for lower-rating bonds. Our model also has new implications that can be tested by further empirical studies.
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