Liquidity and default risk during the 2007 recession: evidence from the korean debt market

Abstract

Credit spreads of corporate bonds over Treasuries are strongly correlated with liquidity and default risks. By looking into the financial crisis period, defined by NBER, we analyze the link between credit spread fluctuation and default and liquidity risk. Specifically, this thesis attempts to explain the yield spread using three factors; default, liquidity and market factors. The default risk is measured by daily Credit Default Swap (CDS) premium data for each sample of Korean banks. We use eight illiquidity components, namely Amihud, Imputed Round-trip Cost, Roll, Amihud risk, IRC risk, Turnover, Zero bond trade, and Zero firm trade, to estimate liquidity level for Korea debt market with various aspects. The level and slope of Korean treasury, and V-KOSPI 200 data are used as market factors in estimating the yield spread. The null hypothesis of this thesis is that there is no relation between yield spread and default, liquidity, and market factors. This hypothesis is rejected by statistical analy-sis. This thesis also proves that the liquidity risk is one of the driving factors of corporate yield spreads during recession from 2007 to 2009. The likelihood ratio of liquidity premium is 10.61. The null hypothesis can be re-jected under a confidence level of 95%. Our empirical result provides an alternative approach to interpret liquid-ity risk and default risk using high frequency bond transaction and CDS contracts in the Korea debt market