Corporate Risk Management

CHAPTER 15Liquidity Risk

Liquidity risk became very important during the last financial crisis (2007–2009). Many financial instruments like bonds, CDOs (collateralized debt obligations), commercial papers, and CDSs (credit default swaps) were strongly affected by this risk.¹ This chapter focuses on corporate bonds and CDSs.

The first question raised by Longstaff, Mithal, and Neis (2005) is: What proportion of bonds' yield spreads is due to default risk? There are many analytical methods to answer this question. The first, proposed by Elton et al. (2001), is to estimate default risk and determine which fraction of the corporate bonds' total credit spread (credit spread below) is due to default risk.² This analysis of default risk was extended by Dionne et al. (2010, 2011). In all three studies, the authors estimate the default probabilities, recovery rates, and risk exposure at default, and then evaluate the proportion of yield spreads explained by estimated default risk. Another approach uses CDSs to measure default risk because the CDS premiums include all this information.

This question, addressed by Longstaff, Mithal, and Neis (2005), is important for corporate finance. The party associated with non-default in yield spreads may affect decisions related to capital structure, asset issues, and risk management of financial institutions. Considering only the default portion may therefore lead to an undervaluation of the required capital.

As Longstaff, Mithal, and Neis (2005) ...