Title: Liquidity risk and corporate risk-taking
Authors: Yuan Wang - Concordia University (Canada) [presenting]
Jingzhi Huang - Penn State University (United States)
Rui Zhong - Central University of Finance and Economics (China)
Abstract: A theoretical framework is constructed to investigate the impact of liquidity risk, in the secondary corporate debt market, on corporate risk-taking preferences. Using closed-form solutions, our model shows that equity holders choose to adopt high-risk projects upon the arrival of illiquidity shocks. This effect is more pronounced for firms with weaker fundamentals. Empirically, we confirm the positive relationship between liquidity risk and corporate risk-taking. We also document that the impact of liquidity risk on corporate risk-taking preferences is more pronounced for smaller firms and firms with lower profits and higher rollover risk. In addition, we use the introduction of the Trade Reporting and Compliance Engine (TRACE) as a natural exogenous liquidity shock and find a decrease of firms risk-taking preferences after the TRACE is implemented. Our findings shed light on the managerial behavior literature, which shows that the frictions of the secondary bond market have a real impact on firms risk-taking behaviors.