Interaction of credit and liquidity risks: Modelling and valuation |
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Institution: | 1. School of Finance, Shanghai University of Finance and Economics, Shanghai, China;2. Shanghai Key Laboratory of Financial Information Technology, School of Finance, Shanghai University of Finance and Economics, Shanghai, China |
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Abstract: | In this paper we discuss the interaction of default risk and liquidity risk on pricing financial contracts. We show that two risks are almost indistinguishable if the underlying contract has non-negative values; however, if it can take both positive and negative values then these two risks demand different risk premiums depending on their loss rates and distributions. We discuss a structural default model and a discrete time default model with exponentially distributed liquidity shocks. We show that short-term yield spreads are dominated by liquidity risk rather than credit risk. We suggest a two-stage procedure to calibrate the model with one scalar optimization problem and one linear programming problem. |
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