A Model of Corporate Bond Pricing with Liquidity and Marketability Risk

by Pierre Tychon of the European Investment Bank,
Vincent Vannetelbosch of FNRS & CORE, Université catholique de Louvain

August 19, 2005

Abstract: We develop a corporate bond valuation model that takes into account both the risk of early default and the risk generated by lack of liquidity and marketability. Randomly matched investors who have heterogeneous prior beliefs about the value of the firm in bankruptcy bargain for the price of the asset in a secondary market. The liquidity and marketability risk is shown to be a function of the heterogeneity of investors' valuations, the average belief about the cost of bankruptcy and the bargaining power of bondholders. The model also captures the fact that, soon after the issue, a bond is relatively liquid and later becomes relatively illiquid depending on the underlying asset value.

JEL Classification: G1, G12, G13, G33.

Keywords: Corporate bond, Liquidity-marketability risk, Valuation, Bankruptcy cost, Bargaining, Matching.

Published in: Journal of Credit Risk, Vol. 1, No. 3, (Summer 2005), pp. 3-35.

Previously titled: A Model of Corporate Bond Pricing with Liquidity/Marketability Risk --and before that-- Debt Valuation and Marketability Risk

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