EECS 1541 Lecture Notes - Lecture 37: Liquidity Risk, Credit Risk, Risk Premium
24 Jun 2018
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EECS 1541 Lecture 37 Notes
Introduction
Credit Risk
Liquidity risk is the potential for the value of bonds to be lower at the time they are for
sale because no consistently active market exists for them.
Thus, investors who wish to sell the bonds may have to lower their price in order to do
so.
A consistently active market entails a nearly continuous set of buyers and sellers of the
bonds, which reduces liquidity risk.
So when international bonds are not actively traded, an investor must sell them at a
discount in order to entice other investors to purchase them in the secondary market.
The credit risk of international bonds is the potential for default: interest and/or
principal payments to investors being suspended either temporarily or permanently.
This risk is especially relevant in countries where creditor rights are limited, because
creditors may be unable to require that debtor firms take the actions necessary to
enable debt repayment.
Even if the firm that issued the bonds is still meeting its periodic coupon payments,
adverse economic or firm-specific conditions can increase the perceived likelihood of
bankruptcy by the issuing firm.
As the credit risk of the issuing firm increases, the risk premium required by investors
also increases.
Consequently, the required return on these bonds rises because potential investors will
seek compensation for the increase in credit risk.
Any investors who want to sell their holdings of the bonds under these conditions must
sell the bonds for a lower price to compensate potential buyers for the credit risk.
International Integration of Credit Risk
Document Summary
Liquidity risk is the potential for the value of bonds to be lower at the time they are for sale because no consistently active market exists for them. Any investors who want to sell their holdings of the bonds under these conditions must sell the bonds for a lower price to compensate potential buyers for the credit risk. The general credit risk levels of loans among countries are correlated because country economies are correlated. Risk is the potential for the value of bonds to be lower at the time they are for sale because no consistently active market exists for them. Thus, investors who wish to sell the bonds may have to lower their price in order to do so. A consistently active market entails a nearly continuous set of buyers and sellers of the bonds, which reduces liquidity risk.
