Liquidity Risk and Volatility Risk in Credit Spread Models: A Unified Approach

Abstract

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.

Keywords: liquidity risk, volatility risk, credit risk, structural model