Research Of Dynamic Relationship Between Credit Spread And Market Liquidity

Credit Spread is the excess return of credit bond yield over risk-free rate,which is compensated for the default risk of the company investors bear. However, existing research shows that credit risk factors explain only a small part of the credit spread, the rest is mostly explained by other factors,which is called "credit spread puzzle". Related studies have shown that the liquidity factor is important to explain credit spreads, but existing bond market liquidity measurement methods are based on the market microstructure, which are not good proxy variables reflecting the overall bond market liquidity, and the market microstructure method noise is large. In this paper, based on diffiences of market liquidity in China’s exchange and Inter-bank market, I propose a new proxy variable of market liquidity. In order to study the factors on interbank market bonds’credit spread, I establish the multiple regression model that controls the interest rate and credit risk factors, and at the same time join the proposed liquidity variable, find that it can promote the R2of the model, so that I can conclude that the liquidity premium is the systematic factor of credit spread.This paper will further discuss the dynamic relationship between credit spread and liquidity premium. I use methods of VAR and Granger Causality Test to study how the prior period liquidity premium affects credit spread and find that when the prior period liquidity premium rises, credit spread will widen.In order to distinguish effects of different economic conditions on credit spread and avoid the effects of distinguishing time point by man, this paper then introduce Markov-regime Switching Model to endogenously confirm the effects of liquidity premium on credit spread and probabilities of two regimes and verify the liquidity risk’s influence on credit spread is time-varying, the empirical results show that the liquidity effect on credit spread under normal and crisis mechanism has significant differences. The influence degree of the mechanism under crisis mechanism is significantly higher than normal. The empirical results also find that the conclusion of the bond market in Dick-Nielsen, Feldhutter, Lando (2012) also applies in China:in crisis mechanism, the impact of market liquidity premium on credit spread is lower than the impact on the high-grade debt credit spread, but the duration of the impact is less than the high-rated bond. In addition, the empirical results of MSVAR model also show that the impact of changes of credit spread in the previous period on illiquidity of this period not only differs in the different degrees, but also in the opposite direction:under the crisis mechanism, the entrance of the configuration type or transaction type funds will ease market illiquidity, therefore rendering the previous period changes in credit spread have a significant negative impact on the current illiquidity changes; under the normal mechanism, however, impact of prior period changes in credit spread on the current illiquidity changes is positive and insignificant.