Endogenous liquidity and defaultable bonds

Research output: Contribution to journalArticlepeer-review

72 Scopus citations

Abstract

This paper studies the interaction between default and liquidity for corporate bonds that are traded in an over-the-counter secondary market with search frictions. Bargaining with dealers determines a bond's endogenous liquidity, which depends on both the firm fundamental and the time-to-maturity of the bond. Corporate default decisions interact with the endogenous secondary market liquidity via the rollover channel. A default-liquidity loop arises: Assuming a relative illiquid secondary bond market in default, earlier endogenous default worsens a bond's secondary market liquidity, which amplifies equity holders' rollover losses, which in turn leads to earlier endogenous default. Besides characterizing in closed form the full interdependence between liquidity and default for credit spreads, our calibrated model can jointly match empirically observed credit spreads and liquidity measures of bonds across different rating classes.

Original languageEnglish (US)
Pages (from-to)1443-1508
Number of pages66
JournalEconometrica
Volume82
Issue number4
DOIs
StatePublished - Jul 2014

Keywords

  • Bid-ask spread
  • Liquidity
  • Over-the-counter market
  • Positive feedback
  • Secondary bond market
  • Structural models for credit risk
  • Transaction cost for corporate bonds

ASJC Scopus subject areas

  • Economics and Econometrics

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