Dynamic interaction between liquidity and sovereign credit risk : evidence from Turkey

In this thesis, the dynamic interaction between liquidity and credit risk for Turkey, which highly needs capital inflow to finance its current account deficit, is examined. A firm/country defaults when it is unable to pay the lender (buyer of its bond) expected cash flows it committed to pay. Bond holders expect to be compensated by a premium in exchange for bearing default risk. Liquidity, on the other hand, is basically defined as the ease of trading a security, especially in large quantities quickly, at low cost and without moving the price. The investors require a premium for a possible difficulty in selling the securities in question. Although, there is a vast literature on the question of how to measure liquidity and default (credit) risk and the pricing impact of these two risk factors on financial assets, the dynamic interaction between these two has received very little attention, especially for sovereign (government) securities. If it turns out that credit (liquidity) risk affects liquidity (credit) risk, then any (precautionary) measures to improve one of these risks may alleviate the severe implication of the other. To this end, we used a model proposed in the literature to observe the dynamic interaction between liquidity and credit risk for Turkey. Using sovereign bond market data of Turkey, we build three different measures for liquidity and exploit sovereign Credit Default Swap (CDS) spreads to proxy credit risk in order to observe lead-lag relation between these two risk factors in a Vector Auto Regressive (VAR) setting. We find significant evidence of Granger-causality in both daily and monthly terms.