TAILIEUCHUNG - Liquidity and Credit Risk

The strong growth of credit in both cases, however, does not mean that domestic credit was the only source for finance of enterprises. In both cases, retained savings by the enterprises played an important role (in China today, these retained savings are an important factor to explain the high national saving rate). However, it can well be argued that the strong credit creation is a necessary condition for profit growth in an economy: Only if credit creation helps to maintain a high level of aggregate demand, firms will be able to make sufficient profits in the aggregate. For the export. | THE JOURNAL OF FINANCE VOL. LXI NO. 5 OCTOBER 2006 Liquidity and Credit Risk JAN ERICSSON and OLIVIER RENAULT ABSTRACT We develop a structural bond valuation model to simultaneously capture liquidity and credit risk. Our model implies that renegotiation in financial distress is influenced by the illiquidity of the market for distressed debt. As default becomes more likely the components of bond yield spreads attributable to illiquidity increase. When we consider finite maturity debt we find decreasing and convex term structures of liquidity spreads. Using bond price data spanning 15 years we find evidence of a positive correlation between the illiquidity and default components of yield spreads as well as support for downward-sloping term structures of liquidity spreads. Credit risk and liquidity risk have long been perceived as two of the main justifications for the existence of yield spreads above benchmark Treasury notes or bonds see Fisher 1959 . Since Merton 1974 a rapidly growing body of literature has focused on credit However while concern about market liquidity issues has become increasingly marked since the autumn of 1998 2 liquidity remains a relatively unexplored topic in particular liquidity for defaultable This paper develops a structural bond pricing model with liquidity and credit risk. The purpose is to enhance our understanding of both the interaction between these two sources of risk and their relative contributions to the yield spreads on corporate bonds. Throughout the paper we define liquidity as the ability to sell a security promptly and at a price close to its value in frictionless markets that is we think of an illiquid market as one in which a sizeable discount may have to be incurred to achieve immediacy. We model credit risk in a framework that allows for debt renegotiation as in Fan and Sundaresan 2000 . Following Francois and Morellec 2004 we also introduce uncertainty with respect to the timing and occurrence of .

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