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

29 Pages Posted: 5 Nov 2017

See all articles by Stylianos Perrakis

Stylianos Perrakis

Concordia University, Quebec - John Molson School of Business

Rui Zhong

The University of Western Australia - UWA Business School

Date Written: November 2017

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

Suggested Citation

Perrakis, Stylianos and Zhong, Rui, Liquidity Risk and Volatility Risk in Credit Spread Models: A Unified Approach (November 2017). European Financial Management, Vol. 23, Issue 5, pp. 873-901, 2017, Available at SSRN: https://ssrn.com/abstract=3064973 or http://dx.doi.org/10.1111/eufm.12127

Stylianos Perrakis (Contact Author)

Concordia University, Quebec - John Molson School of Business ( email )

1455 de Maisonneuve Blvd. W.
Montreal, Quebec H3G 1M8
Canada

Rui Zhong

The University of Western Australia - UWA Business School ( email )

35 Stirling Highway
Crawley, Western Australia 6009
Australia

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