Pricing Corporate Bonds with Credit Risk, Liquidity Risk, and Their Correlation
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...
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| Main Authors: | , , , |
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| Format: | Article |
| Language: | English |
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Wiley
2021-01-01
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| Series: | Discrete Dynamics in Nature and Society |
| Online Access: | http://dx.doi.org/10.1155/2021/6681035 |
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| _version_ | 1832563460785831936 |
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| author | Xinting Li Baochen Yang Yunpeng Su Yunbi An |
| author_facet | Xinting Li Baochen Yang Yunpeng Su Yunbi An |
| author_sort | Xinting Li |
| collection | DOAJ |
| description | 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. |
| format | Article |
| id | doaj-art-e1bacde6736b44bd82b68304c72e330d |
| institution | Kabale University |
| issn | 1026-0226 1607-887X |
| language | English |
| publishDate | 2021-01-01 |
| publisher | Wiley |
| record_format | Article |
| series | Discrete Dynamics in Nature and Society |
| spelling | doaj-art-e1bacde6736b44bd82b68304c72e330d2025-02-03T01:20:09ZengWileyDiscrete Dynamics in Nature and Society1026-02261607-887X2021-01-01202110.1155/2021/66810356681035Pricing Corporate Bonds with Credit Risk, Liquidity Risk, and Their CorrelationXinting Li0Baochen Yang1Yunpeng Su2Yunbi An3College of International Relations, National University of Defense Technology, Nanjing 210000, ChinaCollege of Management and Economics, Tianjin University, Tianjin 300072, ChinaCollege of Management and Economics, Tianjin University, Tianjin 300072, ChinaOdette School of Business, University of Windsor, Windsor N9B3P4, CanadaThis 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.http://dx.doi.org/10.1155/2021/6681035 |
| spellingShingle | Xinting Li Baochen Yang Yunpeng Su Yunbi An Pricing Corporate Bonds with Credit Risk, Liquidity Risk, and Their Correlation Discrete Dynamics in Nature and Society |
| title | Pricing Corporate Bonds with Credit Risk, Liquidity Risk, and Their Correlation |
| title_full | Pricing Corporate Bonds with Credit Risk, Liquidity Risk, and Their Correlation |
| title_fullStr | Pricing Corporate Bonds with Credit Risk, Liquidity Risk, and Their Correlation |
| title_full_unstemmed | Pricing Corporate Bonds with Credit Risk, Liquidity Risk, and Their Correlation |
| title_short | Pricing Corporate Bonds with Credit Risk, Liquidity Risk, and Their Correlation |
| title_sort | pricing corporate bonds with credit risk liquidity risk and their correlation |
| url | http://dx.doi.org/10.1155/2021/6681035 |
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