Panel Data Analysis of Default Risk on Equity Liquidity

This paper represents an empirical study of relationship between credit risk on equity liquidity of the firm. As the default likelihood of corporate entity rises, the informed traders enhance their involvement. Since market markers do not have an insider informational channel, they widen spreads in order to increase profits and compensate the expected losses incurred in trading with informed traders, which results in the worsening of corporate liquidity characteristics. This problem is even more severe when market experience stressful financial conditions. Thus, the protection incentive of market maker rises even higher, while spreads are even wider. By using reduced-form models the default probability could be estimated. Due to the complexity the default component has been obtained from Thompson Reuters EIKON database, which calculates it in the similar way. I test the relationship between probability of default and percentage bid-ask spread for the period from December 2014 to December 2016 by several methods. The results of testing the relationship between default likelihood and bid-ask spread indicates that default probability is an important predictor. Indeed, firms with higher financial distress conditions have higher bid-ask spreads. What is more the threshold model showed that the dependence is non-linear, while above threshold values contribute more in forming bid-ask spread. Worse financial position of the corporate entity and high default probability lead to higher asymmetric information costs. As the result market makers widen bid-ask spreads in order to protect themselves from incurring substantial expected losses while trading with informed traders.