Defaultable bond liquidity spread estimation: an option-based approach

TL;DR

This paper introduces an option-based model to estimate liquidity spreads for corporate bonds, considering risk-free rate volatility and credit risk, with practical application to Italian government bonds.

Contribution

It extends an option-theoretic framework to quantify bond liquidity spreads, incorporating marketability factors and providing a calibration method using real market data.

Findings

Liquidity spreads are significantly affected by risk-free rate volatility and credit risk.

The model effectively differentiates between liquid and illiquid bonds.

Application to Italian bonds demonstrates practical utility in bond valuation.

Abstract

This paper extends an option-theoretic approach to estimate liquidity spreads for corporate bonds. Inspired by Longstaff's equity market framework and subsequent work by Koziol and Sauerbier on risk-free zero-coupon bonds, the model views liquidity as a look-back option. The model accounts for the interplay of risk-free rate volatility and credit risk. A numerical analysis highlights the impact of these factors on the liquidity spread, particularly for bonds with different maturities and credit ratings. The methodology is applied to estimate the liquidity spread for unquoted bonds, with a specific case study on the Republic of Italy's debt, leveraging market data to calibrate model parameters and classify liquid versus illiquid emissions. This approach provides a robust tool for pricing illiquid bonds, emphasizing the importance of marketability in debt security valuation.