Open AccessPricing Corporate Bonds with Credit Risk, Liquidity Risk, and Their Correlation
Author(s) -
Xinting Li,
Baochen Yang,
Yunpeng Su,
Yunbi An
Publication year - 2021
Publication title -
discrete dynamics in nature and society
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.264
H-Index - 39
eISSN - 1607-887X
pISSN - 1026-0226
DOI - 10.1155/2021/6681035
Subject(s) - liquidity risk , credit risk , market liquidity , liquidity premium , bond , liquidity crisis , corporate bond , business , financial economics , market risk , bond valuation , financial risk management , economics , econometrics , financial system , monetary economics , actuarial science , risk management , finance
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.