Liquidity Risk of Corporate Bond Returns

liquidity risk of corporate bonds is highly conditional in nature, especially for … flows (expected loss) on corporate bonds by employing a time-series of …

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Liquidity Risk of Corporate Bond Returns
3 We call it a \”liquidity\” risk premium and not a generalized riskpremium, since we found that in the stress times we examine or identify in data, there isno such increase in the sensitivity of returns to traditional risk factors such as interest ratesand default risk. The idea flows from Amihud and Mendelson(1986) that in equilibrium, liquid asset are held by more frequently-trading investors. S. Goyenko (2005) studiesthe cross-market effect of liquidity and finds that stock returns as well as Treasury bondreturns are affected by both stock and bond liquidity shocks. This also results in eliminating data for all bonds with a maturity of less than oneyear. This may not howeverbe the case. After all, the separationbetween these categories is (supposedly) primarily due to their different credit risks. There are twoclear regimes and importantly these are regimes in liquidity betas. Specifically, as for Tables 5 and 6,we first convert the model-implied probability of being in stress regime into a binary variablewhich is set to one if the probability is higher than 70% (which gives us about 25% of data asbeing in stress regime), and zero otherwise. When all five variables are usedto employ the model-implied probability of being in the stress regime of liquidity risk ofcorporate bond returns, the negative stock market return, Hamilton probability of being inlow regime of GNP growth rate and CFNAI index being low are significantly and positivelycorrelated.

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