Measuring Liquidity Premia in Corporate Bonds
Summary
The document considers how to distinguish a bond’s underlying value from liquidity and funding components, especially when corporate bond and credit default swap spreads diverge. It frames the problem as relevant to stress risk modeling and asks how liquidity or funding premia might be defined, including whether recovery assumptions affect their stability. The responses do not provide a complete decomposition model, but point to empirical measures and research on corporate bond liquidity.
One cited approach combines price impact and its variability, spread covariance and its variability, turnover, estimated round-trip costs, and the frequency of days without trading into a composite liquidity measure. The discussion also mentions statistical analysis with confidence bands and other studies of liquidity, price discovery, and corporate yield spreads. These measures can help describe market conditions, but the document leaves the recovery-rate question unanswered and does not establish a functional form that cleanly separates true value, liquidity, and funding effects.
Key ideas
- Bond and credit default swap spreads can diverge, with liquidity, funding, or counterparty effects as possible explanations.
- A composite liquidity measure can combine price impact, spread covariance, turnover, estimated trading costs, and inactive days.
- Historical liquidity indicators can inform stress analysis, but they do not alone identify a unique liquidity premium.
- The cited discussion leaves the effect of recovery-rate assumptions unresolved.
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Full text
# How to define and measure liquidity or funding premium in credit markets? # How to define and measure liquidity or funding premium in credit markets? Even companies with just a single non-callable corporate bond outstanding will often have CDS quote spreads that differ from the bond quote spread. During the 2008 crisis, there were dozens of cases where true arbitrages were available. You could argue these arbitrages were due to forced selling of bond inventory (a funding premium), aversion to bond trading (looks like a liquidity premium) or depression of CDS spreads due to counterparty risk. If I want to risk model what may happen in another crisis, I would like a model of where such liquidity/funding spreads might go again. To do that, I can look at history, but first I need to separate a price $V$ out into a "true" price $V_T$ plus liquidity and/or funding components $V_L$ and $V_F$. Has anybody found reasonable definitions and functional forms of these? If you have, what was the influence of recovery rates on their stability? ## Answer by Brian B (score 3) https://quant.stackexchange.com/a/2482 I just reviewed the paper Corporate Bond Liquidity Before and After the Onset of the Subprime Crisis by Dick-Nielsen, Feldhütter and Lando. They define a liquidity measure $\lambda$ as a conglomerate of - price impact (Amihud) and its variability - spread covariance (Roll) and its variability - turnover - imputed roundtrip cost (Feldhütter) - zero trading days I rather like the last one, since it captures a lot of the ugliness in corporate bond markets. Having defined $\lambda$, they run some statistics to work out liquidity premia, including setting confidence bands using a "wild cluster bootstrap" which I am going to have study just because of the awesome name. The question of perceived recovery rates is still outstanding. ## Answer by Ryogi (score 1) https://quant.stackexchange.com/a/2510 The paper by Tavi Ronen is interesting in its analysis of the liquidity and price discovery. - Where Did All the Information Go? Trade in the Corporate Bond Market As I pointed out above a simple measure is the one by Boa et al in their - "Illiquidity of corporate bonds" (see link in my comment to Brian's answer) For a very different take on what being illiquid means, the paper by Rossi is very interesting - “Realized Volatility, Liquidity, and Corporate Yield Spreads” Even if it is not clear from the title, the gist of it is that from the low liquidity something can inferred about the value of the current misplacing in corporate bonds (simply put, the trading costs are larger than the mispricings).
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