Abstract
This paper proposes a generalized bond pricing model, accounting for all the effects of credit risk, liquidity risk, and their correlation. We use an informed trading model to specify the bond liquidity payoff and analyze the sources of liquidity risk. We show that liquidity risk arises from reduced information accuracy and market risk tolerance, and it is market risk tolerance that links credit and liquidity. Then, we extend the traditional bond pricing model with only credit risk by incorporating liquidity risk into the framework in which the probabilities of the two risk events are estimated by a joint distribution. Using numerical examples, we analyze the role of the correlation between credit and liquidity in bond pricing, especially during a financial crisis. We document that the varying correlation between default and illiquidity explains the phenomenon of bond death spiral observed in a financial crisis. Finally, we take the US corporate bond market as an example to demonstrate our conclusions.
Highlights
Unlike government bonds, corporate bonds require risk compensation, which is referred to as yield spreads. e risk of corporate bonds is typically classified into two categories: credit risk and liquidity risk [1,2,3,4,5]
We find that bond liquidity risk arises from reduced information accuracy and market risk tolerance. e first factor reflects the opacity of information and investors’ ability to capture the information, which are determined by exogenous factors such as market regulations and the overall quality of market investors. is factor is independent of the credit level of bonds
Where i 1 or 2 represent different regimes. e dependent variable yst is the corporate bond yield spread, and the independent variable SPt × ct is the product of credit risk and liquidity risk, which are measured by the S&P rating level and illiquidity proxy proposed by Bao etal. [41], respectively
Summary
Corporate bonds require risk compensation, which is referred to as yield spreads. e risk of corporate bonds is typically classified into two categories: credit risk and liquidity risk [1,2,3,4,5]. Using a Markov-switching model to describe the changes of the relationship between yield spreads and risk factors, we show that the correlation plays an important role in bond market during financial crisis. The reduced model is better able to evaluate the probability and loss of credit risk by using historical default and trade data instead of the companies’ asset value information. Jarrow et al [15] propose a reduced-form approach for valuing callable corporate bonds by characterizing the call probability via an intensity process Following this line of thought, we develop a model framework that accommodates both credit risk and liquidity risk, in which the two risks are characterized by two events, default and trade, meaning the end of a lending relationship. We need to evaluate bondholders’ losses arising from default or trade and the instantaneous probabilities of the two related events
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