This paper presents a new dynamic term structure model that addresses both liquidity and credit risk premia in bond prices. The model ensures an arbitrage-free framework, considering liquidity risk as specific to individual bonds, while credit risk is common across bonds. Credit risk follows a square-root process for nonnegativity and econometric identification.
A simulation study supports the separate identification of these risks. The model was applied to South African government bond prices, revealing significant but weakly correlated liquidity and credit risk premia. This finding highlights the distinct nature of liquidity and credit stresses faced by bond investors.
“While liquidity risk is bond-specific, credit risk is common across bonds,” states the paper. “A simulation study confirms the separate identification of liquidity and credit risk.”
The application of this model to South African government bonds underscores that “liquidity and credit stresses are distinct risks to bond investors.”
