Dynamic Interactions Between Interest Rate, Credit, and Liquidity Risks: Theory and Evidence from the Term Structure of Credit Default Swap Spreads

Using a large data set on credit default swaps, we study how default risk interacts with interest-rate risk and liquidity risk to jointly determine the term structure of credit spreads. We classify the reference companies into two broad industry sectors, two broad credit rating classes, and two liquidity groups. We develop a class of dynamic term structure models that include (i) two benchmark interest-rate factors to capture the libor and swap rates term structure, (ii) two credit-risk factors to capture the credit swap spreads of high-liquidity group of each industry and rating class, and (iii) both an additional credit-risk factor and a liquidity-risk factor to capture the difference between the highand low-liquidity groups. Estimation shows that companies in different industry and credit rating classes have different credit-risk dynamics. Nevertheless, in all cases, credit risks exhibit intricate dynamic interactions with the interestrate factors. Interest-rate factors both affect credit spreads simultaneously, and impact subsequent moves in the credit-risk factors. Within each industry and credit rating class, we also find that the average credit default swap spreads for the high-liquidity group are significantly higher than for the low-liquidity group. Estimation shows that the difference is driven by both credit risk and liquidity differences. The low-liquidity group has a lower default arrival rate and also a much heavier discounting induced by the liquidity risk. JEL CLASSIFICATION CODES: E43, G12, G13, C51.