Liquidity and Credit Risk

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.     

Do liquidity or credit effects explain the behavior of the BKBM–LIBOR differential?

This paper examines the evolution of the relationship between the onshore and offshore benchmarks for New Zealand dollar funding during the global financial crisis. In August 2007 the BKBM–LIBOR differential switched from positive to negative and then widened considerably following the collapse of Lehman Brothers in September 2008, before narrowing gradually as the turmoil in financial markets subsided. Our structural regression model and decomposition analyses show that changes in liquidity, proxied by bid/ask spreads, largely explain the changes in the BKBM–LIBOR differential over this period and that credit risk factors only played a minor role. However our analysis also shows that bid/ask spreads in the offshore market price information regarding counterparty credit risk, suggesting that our initial results could understate the role played by credit risk factors.     

The determinants of sovereign credit spread changes in the Euro-zone

Using a database of Euro-denominated government bonds covering the period from January 2000 to December 2010, this paper provides an empirical analysis of the determinants of government credit spreads in the Euro-area. The analysis is divided into two sub-periods delimited by the global financial crisis that started in August 2007. We find evidence of a clear shift in the behavior of market participants from a convergence-trade expectation, based on market related factors, before August 2007, to one mainly driven by macroeconomic country-specific variables and an international common risk factor. There is no evidence of a significant role for the liquidity risk before or during the financial crisis period. Overall, our results give support to the Merton-type structural credit risk models and confirm that there are considerable similarities between the factors explaining the dynamics of the credit risk spreads and the factors driving the prices on the government bond markets.     

Price discovery of credit spreads in tranquil and crisis periods

In this paper we investigate the price discovery process in single-name credit spreads obtained from bond, credit default swap (CDS), equity and equity option prices. We analyse short term price discovery by modelling daily changes in credit spreads in the four markets with a vector autoregressive model (VAR). We also look at price discovery in the long run with a vector error correction model (VECM). We find that in the short term the option market clearly leads the other markets in the sub-prime crisis (2007–2009). During the less severe sovereign debt crisis (2009–2012) and the pre-crisis period, options are still important but CDSs become more prominent. In the long run, deviations from the equilibrium relationship with the option market still lead to adjustments in the credit spreads observed or implied from other markets. However, options no longer dominate price discovery in any of the periods considered. Our findings have implications for traders, credit risk managers and financial regulators.     

Internal liquidity risk in corporate bond yield spreads

The recent global financial crisis reveals the important role of internal liquidity risk in corporate credit risk. However, few existing studies investigate its effects on bond yield spreads. Panel data for the period from year 1993 through 2008 show that corporate internal liquidity risk significantly impacts bond yield spreads (and changes) when controlling for well-known bond yield determinant variables, traditional accounting measures of corporate debt servicing ability, cash flow volatility, credit ratings, and state variables. This finding indicates that internal liquidity risk should therefore be incorporated into bond yield spread modeling.     

Do sovereign credit default swaps represent a clean measure of sovereign default risk? A factor model approach

In this study, we use a factor model in order to decompose sovereign Credit Default Swaps (CDS) spreads into default, liquidity, systematic liquidity and correlation components. By calibrating the model to sovereign CDSs and bonds we are able to present a better decomposition and a more accurate measure of spread components. Our analysis reveals that sovereign CDS spreads are highly driven by liquidity (55.6% of default risk and 44.32% of liquidity) and that sovereign bond spreads are less subject to liquidity frictions and therefore could represent a better proxy for sovereign default risk (73% of default risk and 26.86% of liquidity). Furthermore, our model enables us to directly study the effect of systematic liquidity and flight-to-liquidity risks on bond and CDS spreads through the factor sensitivity matrix. We find that these risks do have an influence on the default intensity and they contribute significantly to spread movements. Finally, our empirical results advance the idea that the increase in the CDS spreads observed during the crisis period was mainly due to a surge in liquidity rather than to an increase in the default intensity.     

Bank credit default swaps and deposit insurance around the world

We investigate the impact of deposit insurance schemes on banks' credit risk – a predictor of failure and a key element in the current financial crisis. Unlike most studies, which use balance sheet measurements of risk, we adopt a forward-looking and market-based measure of bank credit risk: the credit default swap (CDS) spread. We find that banks in countries with explicit deposit insurance systems have higher CDS spreads, supporting the “moral hazard” view. The results suggest that deposit insurance design features that lessen the adverse impact are risk-adjusted premium, coinsurance systems, government-established systems, “risk-minimizing” systems, and systems with dual-funding sources. Full coverage appears to stabilize bank risk only during the financial crisis period. More stringent bank regulation, such as capital adequacy regulation and independent supervision, could reduce the undesirable impact of deposit insurance. Deposit insurance seems to help stabilize volatile markets, as evidenced during the financial crisis and in countries with greater market volatility. In addition, we find that the adverse impact of deposit insurance on bank credit risk is more pronounced for banks with low asset quality and low liquidity.     

Liquidity or Credit Risk? The Determinants of Very Short‐Term Corporate Yield Spreads

Employing a comprehensive database on transactions of commercial paper issued by domestic U.S. nonfinancial corporations, we study the determinants of very short‐term corporate yield spreads. We find that liquidity plays a role in the determination of spreads but, somewhat surprisingly, credit quality is the more important determinant of spreads, even at horizons of less than 1 month. These results are robust across a variety of proxies for liquidity and credit risk, and have important implications for the literature on the modeling of corporate bond prices.     

Pricing Sovereign Credit Risk of Poland: Evidence from the CDS Market

We analyze the market assessment of sovereign credit risk using a reduced-form model to price the credit default swap (CDS) spreads, thus enabling us to derive values for the probability of default (PD) and loss given default (LGD) from the quotes of sovereign CDS contracts. We compare different specifications of the models allowing for both fixed and time-varying LGD, and we use these values to analyze the sovereign credit risk of Polish debt throughout the period of a global financial crisis. Our results suggest the presence of a low LGD and a relatively high PD during a recent financial crisis.     

Factor decomposition of the Eurozone sovereign CDS spreads

In the present study, we examine the factors driving Eurozone sovereign credit default swap (CDS) spreads during the Eurozone sovereign debt crisis. For identifying factors we utilize independent component analysis (ICA), a technique similar to principal component analysis (PCA). We identify three factors that impact spreads and capture the features specific to the crisis such as the breakup risk of the Eurozone: peripheral factor, global factor, and Eurozone common factor. In contrast, when PCA is applied, only a single factor is identified. Moreover, using ICA with a GARCH model, we show that the source of volatility for CDS spreads shifted from the global factor in 2009 and the peripheral factor in 2010 to the Eurozone common factor in 2012, and that the dynamic correlation reflects the decoupling between low credit risk countries such as Germany and high credit risk countries such as Greece. We also show that the goodness-of-fit of the ICA-based model is better than other models used such as the Student's t copula model.     

Finance companies in Mexico: Unexpected victims of the global liquidity crunch

We study the connection between the global liquidity crisis and the severe credit crunch experienced by finance companies (SOFOLES) in Mexico using firm-level data between 2001 and 2011. Our results provide supporting evidence that, as a result of the liquidity shock, SOFOLES faced severely restricted access to their main funding sources (commercial bank loans, loans from other organizations, and public debt markets). After controlling for the potential endogeneity of their funding, we find that the liquidity shock explains 64 percent of SOFOLES’ credit contraction during the recent financial crisis (2008–2009). We use our estimates to disentangle supply from demand factors as determinants of the credit contraction. After controlling for the large decline in loan demand during the financial crisis, our findings suggest that supply factors (such as nonperforming loans and lower liquidity buffers) also played a significant role. Finally, we find that financial deregulation implemented in 2006 may have amplified the effects of the global liquidity shock.     

Credit and liquidity components of corporate CDS spreads

This paper investigates the role of credit and liquidity factors in explaining corporate CDS price changes during normal and crisis periods. We find that liquidity risk is more important than firm-specific credit risk regardless of market conditions. Moreover, in the period prior to the recent “Great Recession” credit risk plays no role in explaining CDS price changes. The dominance of liquidity effects casts serious doubts on the relevance of CDS price changes as an indicator of default risk dynamics. Our results show how multiple liquidity factors including firm specific and aggregate liquidity proxies as well as an asymmetric information measure are critical determinants of CDS price variations. In particular, the impact of informed traders on the CDS price increases when markets are characterised by higher uncertainty, which supports concerns of insider trading during the crisis.     

The liquidity impact on firm values: The evidence of Taiwan's banking industry

Liquidity plays an important role in financial markets, especially during a financial crisis. New Basel III regulatory framework highlights the importance of liquidity risk management implemented by financial institutions. Moreover, updated International Financial Reporting Standards (IFRS) require the improvements about fair value measurements and reinforce existing principles for disclosures about the liquidity risk associated with financial instruments. Using the liquidity discount model of Chen (2012), we are able to empirically classify Taiwan's financial institutions into three liquidity categories: safe, crisis contagious and vulnerable. Our findings can serve as an early warning signal for liquidity calamity. In addition, we investigate what factors affect firm-specific liquidity discounts for these institutions and conduct a sub-period analysis, which examines whether there is significant liquidity discounts changes before and after the 2008 financial crisis. We find that liquidity discounts change substantially during the financial crisis. Furthermore, we find that liquidity discounts can be attributed to some firm-specific performance.     

Illiquidity or credit deterioration: A study of liquidity in the US corporate bond market during financial crises

We investigate whether liquidity is an important price factor in the US corporate bond market. In particular, we focus on whether liquidity effects are more pronounced in periods of financial crises, especially for bonds with high credit risk, using a unique data set covering more than 20,000 bonds, between October 2004 and December 2008. We employ a wide range of liquidity measures and find that liquidity effects account for approximately 14% of the explained market-wide corporate yield spread changes. We conclude that the economic impact of the liquidity measures is significantly larger in periods of crisis, and for speculative grade bonds.     

Downside risk and the size of credit spreads

We investigate why spreads on corporate bonds are so much larger than expected losses from default. Systematic factors make very little contribution to spreads, even if higher moments or downside effects are taken into account. Instead we find that sizes of spreads are strongly related to idiosyncratic-risk factors: not only to idiosyncratic equity volatility, but even more to idiosyncratic bond volatility and idiosyncratic bond value-at-risk. Idiosyncratic bond volatility helps to explain spreads because it reflects not just the distribution of firm value but is also a proxy for liquidity risk. Idiosyncratic bond value-at-risk adds to this by capturing the left-skewness of the firm-value distribution. We confirm our results both for the initial 1997-2004 sample period and also out of sample for 2005-2009, which includes the sub-prime crisis. Overall, credit spreads are large because they incorporate a large risk premium related to investors’ fears of extreme losses.     

A Multifactor Model of Credit Spreads

We represent credit spreads across ratings as a function of common unobservable factors of the Vasicek form. Using a state-space approach we estimate the factors, their process parameters, and the exposure of each observed credit spread series to each factor. We find that most of the systematic variation across credit spreads is captured by three factors. The factors are closely related to the implied volatility index (VIX), the long bond rate, and S&P500 returns, supporting the predictions of structural models of default at an aggregate level. By making no prior assumption about the determinants of yield spread dynamics, our study provides an original and independent test of theory. The results also contribute to the current debate about the role of liquidity in corporate yield spreads. While recent empirical literature shows that the level and time-variation in corporate yield spreads is driven primarily by a systematic liquidity risk factor, we find that the three most important drivers of yield spread levels relate to macroeconomic variables. This suggests that if credit spread levels do contain a large liquidity premium, the time variation of this premium is likely driven by the same factors as default risk.     

Credit risk in covered bonds

Covered bonds are a promising alternative for prime mortgage securitization. In this paper, we explore risk premia in the covered bond market and particularly investigate whether and how credit risk is priced. In extant literature, yield spreads between high-quality covered bonds and government bonds are often interpreted as pure liquidity premia. In contrast, we show that although liquidity is important, it is not the exclusive risk factor. Using a hand-collected data set of cover pool information, we find that the credit quality of the cover assets is an important determinant of covered bond yield spreads. This effect is particularly strong in times of financial turmoil and has a significant influence on the issuer's refinancing cost.     

On cross-currency transmissions between US dollar and euro LIBOR-OIS spreads

Using the causality-in-variance and causality-in-mean tests advocated by Hong (2001), we examine volatility and mean transmissions between the US dollar (USD) and euro (EUR) LIBOR-OIS spreads from January 2005 to June 2011. Interestingly, during the global financial crisis period, despite the apparently bidirectional causality-in-mean observed between the two spreads, we find evidence of significant unidirectional causality-in-variance from the EUR to the USD spread, implying information flows driven by the funding behaviors of European financial institutions. On the other hand, during the recent European sovereign debt crisis, we detect no significant causality-in-mean and causality-in-variance between the spreads.     

Systemic Risk,Financial Crisis,and Credit Risk Insurance

Differing from conventional insurance firms whose underwriting business does not contribute to systemic risk, credit risk insurance companies providing credit protections for debt obligations are exposed to systemic risk. We show that credit risk insurers (CRIs) underperformed conventional insurance companies during the 2007–2009 financial crisis, and such underperformance is attributed to the greater systemic risk of CRIs. We also find that the credit spreads of insured bonds increase significantly after their insurers are downgraded or put in the negative watch list. We control for alternative factors affecting bond credit spreads and the result is robust.     

Stressed,Not Frozen: The Federal Funds Market in the Financial Crisis

We examine the importance of liquidity hoarding and counterparty risk in the U.S. overnight interbank market during the financial crisis of 2008. Our findings suggest that counterparty risk plays a larger role than does liquidity hoarding: the day after Lehman Brothers' bankruptcy, loan terms become more sensitive to borrower characteristics. In particular, poorly performing large banks see an increase in spreads of 25 basis points, but are borrowing 1% less, on average. Worse performing banks do not hoard liquidity. While the interbank market does not freeze entirely, it does not seem to expand to meet latent demand.