Abstracts

We present an integrated structural model for credit and liquidity risk which allows to determine an optimal debt maturity structure. We consider a firm which finances its risky assets by a mixture of short- and long-term debt as well as equity. The firm is exposed to its internal funding liquidity risk (rollover risk) through possible runs by short-term creditors. When creditors' have less faith in the firm's ability to either draw on its pre-committed credit lines from other financial institutions or to pledge its risky assets as collateral to raise new funding, this leads to increasing credit spreads to prevent creditors to withdraw their funding.
In our model credit spreads are derived endogenously at rollover dates while equity holders have to bear the gains and losses from rolling over short-term debt subject to their limited liability.
When funding liquidity dries up and the firm cannot raise further equity, it is forced to prematurely liquidate its assets on a secondary market for a firesale price. External market liquidity enters our model as firesale rates depend on the overall market situation. When the firm pledges its risky assets as collateral to raise new capital, investors impose margin requirements to ensure that the collateral is sufficient to cover the firm's value-at-risk or expected shortfall. Both quantities highly depend on the volatility of the firm's fundamental value which we model stochastically in a Heston framework.
When there is a liquidity shock to the overall financial market, volatilities increase. This induces creditors to become more risk averse and to require higher margins such that the assets sell at lower firesale rates. This again reinforces the firm's exposure to funding liquidity risk. Through this channel macro-economic effects, modelled as random shocks to the firm's volatility, influence market liquidity and feed back on the firm's internal funding liquidity through increasing margin requirements of investors.