Article ID Journal Published Year Pages File Type
5091603 Journal of Banking & Finance 2006 17 Pages PDF
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.
Related Topics
Social Sciences and Humanities Economics, Econometrics and Finance Economics and Econometrics
Authors
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