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Liquidity Risk and Volatility Risk in Credit Spread Models: A Unified Approach
Author(s) -
Perrakis Stylianos,
Zhong Rui
Publication year - 2017
Publication title -
european financial management
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.311
H-Index - 64
eISSN - 1468-036X
pISSN - 1354-7798
DOI - 10.1111/eufm.12127
Subject(s) - volatility (finance) , market liquidity , liquidity risk , bond , economics , econometrics , credit risk , financial economics , equity (law) , rollover (web design) , bond market , monetary economics , corporate bond , debt , actuarial science , finance , computer science , world wide web , law , political science
We present an integrated framework incorporating both exogenous liquidity risk in the secondary corporate bond market and volatility risk in the dynamics of asset value in debt rollover models. Using an innovative theoretical approach we derive general expressions for the debt and equity values in all cases. Taking advantage of the analytical expressions for the asset value with the constant elasticity of variance (CEV) process, we show numerically using realistic parameter values from empirical studies that volatility risk, together with deteriorating bond market liquidity, decreases both debt and equity values and significantly increases the credit spreads.